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Central bankers have one tool to break that deflationary spiral: oil


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If I was Yellen, I would immediately contact my Chinese, ECB and Japanese counterparts and mount an operation to prop up the price of oil or at least remove the short punch bowl from Goldman Sachs and some others. I would also call Obama and ask him wtf he is up to with the Saudis.

 

This never ending decline in the price of oil is very negative for many reasons:

 

1- Can`t normalize interest rates. With zero inflation or no fear of it, it is very hard to increase interest rates to a more normal level. With the oil price being so weak, everyone fears that something is wrong and we are at 5.0% unemployment!!!

 

2- This low oil price is going to make S&P earnings negative for the first time since 2008. The implications cannot be clearer: when S&P earnings go down, the S&P has a really hard time staying up which is at some point bad for the economy: wealth effect, fear, etc.

 

3- The longer this continues, the more bankruptcies there will be related to the oil patch. A junk bond panic is not a desirable outcome IMO. While I favour market forces to sort out what is viable and what is not, a 2008 style crisis and the risk of contagion to other markets is not good for anyone.

 

4- Despite strong consumption, with oil being this low you cannot but, wonder if China is about to enter some kind of calamity. If oil was to only go back to $40, a lot of fear would be removed from the Chinese stock market giving them time for their own wealth effect to workout and help their transition away from an entirely export driven economy.

 

5- $40 or $50 oil won`t bring any new supply. You may get some uncompleted wells being put on stream but, there will be no gold rush whatsoever and with what has been cancelled already in the $100`s of billions and decline rates, supply should still come down.

 

As you may guess, I have a vested interest in oil going higher from here. At the same time, I have a vested interest in this World not self destructing itself because of some greedy short idiots or some other conspiration going on (bankrupting Russia?). Moreover, the creation of a massive supply crunch 2 years down the road is going to really hurt the global economy.

 

We are starting to see the unintended consequences of a collapsing oil price. I think that stability is required here and that $60 oil is a desirable outcome: no supply crunch, no depression.

 

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That's assuming the lower energy costs are a bad thing.

 

Perhaps...

Less money spent heating homes, driving cars, and shipping goods around the world may lead to increased spending by consumers, which would lead to more broad-based factory utilization.

 

The factory utilization problem was a result of too much on credit (having temporarily too high spending power)  -- and then when oil prices went up in 2007 it didn't really help... it made it worse.  So it could be reasoned that spending budgets are freed up when oil prices fall.

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I would argue Ericopoly that this benefit from lower oil price has already occurred: SUV sales are at record.

 

My point is that there is a limit as to how far this should be allowed to go since the unintended consequences are much greater than the benefit from savings. It is the multiplier effect that I am worried about.

 

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Cardboard,

 

We just need patience.  So long as my dividends keep coming, even at a reduced rate this can go on for awhile.  Sooner or later things will balance out one way or another.  ie. survivors will brind costs down via wage cuts etc.,  or prices will go up. 

 

I have done catastrophe testing and will do fine even if Russell, ARX, amd WCP dramatically reduce their dividends, like Crescent Point and Mullen did.  I would think Russell may have to, and WCP would probably have to after the second quarter if things dont rebound.  ARx looks good for a couple of years out due to 70% gas, and long term hedges into 2019. 

 

Your idea, while novel, is also very unlikely.  I am with Eric on this.  Lower oil leads to upswings.  At some point in the not too distant future the effects of buying larger vehicles, and cutting oil production will take their toll. 

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Deflation is not a problem. Debt deflation can be a big problem. They are not the same thing!

 

The whole current thinking on macroeconomics is just plain wrong. It all originates with the Great Depression where conventional economics had absolutely no way of explaining what was happening. And still doesn't. So they pinned the blame on deflation instead of on debt repayment . Its utterly ridiculous and contradicted by historical evidence.

 

For instance, from 1800-1900 the US experienced deflation and high rates of economic growth simultaneously. In 1800 the price level in the US was 50% higher than in 1900. The following paper looked into the issue across countries and historical periods and finds deflation is rarely associated with depression.

https://www.minneapolisfed.org/research/sr/sr331.pdf

 

On there other hand if you want to understand the credit cycle and how debt deflation causes recessions and depressions...I can think of no better explanation than that of Ray Dalio

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Deflation is not a problem. Debt deflation can be a big problem. They are not the same thing!

 

The whole current thinking on macroeconomics is just plain wrong. It all originates with the Great Depression where conventional economics had absolutely no way of explaining what was happening. And still doesn't. So they pinned the blame on deflation instead of on debt repayment . Its utterly ridiculous and contradicted by historical evidence.

 

 

Hallelujah!  I also found Murry Rothbard's history of the GD useful on this, especially since I read it after Jim Grant's history of the 1921 depression and the two kind of go together.

 

Personally I'm in favour of free market pricing which means no inflation-targeting by central banks.  I certainly don't see the lower oil price as a bad thing.  And I don't see deflation as being related to low oil so much as to deleveraging.

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If technology is helping extract oil cheaper from the same ground, then deflation of product price is great. Sure it might be undervalued now and the 'right' price is 40 or 50, but I wonder if we want free markets. $33 / $40 is only 18% or so, hardly an amount that the boundaries of market stability are being tested.

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If technology is helping extract oil cheaper from the same ground, then deflation of product price is great. Sure it might be undervalued now and the 'right' price is 40 or 50, but I wonder if we want free markets. $33 / $40 is only 18% or so, hardly an amount that the boundaries of market stability are being tested.

 

$40/$50 looks rather low given the marginal cost of production of new barrels around the world. 60+$ looks better...

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Deflation is not a problem. Debt deflation can be a big problem. They are not the same thing!

 

The whole current thinking on macroeconomics is just plain wrong. It all originates with the Great Depression where conventional economics had absolutely no way of explaining what was happening. And still doesn't. So they pinned the blame on deflation instead of on debt repayment . Its utterly ridiculous and contradicted by historical evidence.

 

For instance, from 1800-1900 the US experienced deflation and high rates of economic growth simultaneously. In 1800 the price level in the US was 50% higher than in 1900. The following paper looked into the issue across countries and historical periods and finds deflation is rarely associated with depression.

https://www.minneapolisfed.org/research/sr/sr331.pdf

 

On there other hand if you want to understand the credit cycle and how debt deflation causes recessions and depressions...I can think of no better explanation than that of Ray Dalio

 

Dalio is brilliant - and he's been concerned that we're coming to the end of a long-term debt cycle and that people are too focused on the short-term debt cycle.

 

Oil isn't the problem. Oil is a symptom. Oil prices were artificially propped up by a weak dollar which was held down by artificially low interest rates forcing people into riskier assets like commodities, EM, etc. etc. etc. The high oil prices drove a lot of investment into the area as new technology was discovered that could reach previously unreachable oil for singificantly cheaper than the current cost. That drove over/malinvestment into energy which increased supply causing a potential a glut. The glut was solidified when OPEC refused to cede market share.

 

You can't look at all commodities being a 3-4 year bear market, except oil, and then suggest that when oil prices fell that they were the cause of the problem. All commodities have been falling for years because they are all affected by the problem - oversupply and malinvestment.

 

It's funny that a few months ago people were expecting lower oil prices to be additive to GDP. Now low oil prices threaten the economy? Here's the deal - consumer behaviors have changed. This is what happens after deep crisis - this is why you need one every 3 generations or so because people forget the lessons learned in the first one. Consumers, who used to spend every penny they earned plus some, no longer spend that. Now they take the majority of their incremental savings from lower prices and use it to continue to deleverage. Raising the price of oil doesn't change that - it would simply delay the catalyst that will eventually occur to cause the system to reset and wipe out the poor investments. We've been delaying that catalyst for 8 years now. Maybe we find a way to delay it more, but a day of reckoning will occur and the longer it takes to get here, the bigger it will be.

 

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Deflation is not a problem. Debt deflation can be a big problem. They are not the same thing!

+1. If you ask most people why deflation is bad they give you the same look as if you asked them why they believe in dinosaurs.

 

I do agree with Cardboard that low oil prices are beginning to be have deeper negative effects. While there's a fair argument that $65 oil is better for the economy than $100 dollar, $33 oil presents a lot of difficulties around the world. At the least, it seems like a good time to cap off the strategic petroleum reserves.

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Deflation is not a problem. Debt deflation can be a big problem. They are not the same thing!

+1. If you ask most people why deflation is bad they give you the same look as if you asked them why they believe in dinosaurs.

 

I do agree with Cardboard that low oil prices are beginning to be have deeper negative effects. While there's a fair argument that $65 oil is better for the economy than $100 dollar, $33 oil presents a lot of difficulties around the world. At the least, it seems like a good time to cap off the strategic petroleum reserves.

 

Instead of doing the opposite?  This is how stupid our policy makers are.

 

http://www.bloomberg.com/news/articles/2015-10-27/u-s-plans-to-sell-down-strategic-oil-reserve-to-raise-cash

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Deflation is not a problem. Debt deflation can be a big problem. They are not the same thing!

+1. If you ask most people why deflation is bad they give you the same look as if you asked them why they believe in dinosaurs.

 

I do agree with Cardboard that low oil prices are beginning to be have deeper negative effects. While there's a fair argument that $65 oil is better for the economy than $100 dollar, $33 oil presents a lot of difficulties around the world. At the least, it seems like a good time to cap off the strategic petroleum reserves.

 

I would love to hear the argument that $65 oil is better for the economy than $33 oil.  Personally, I would prefer $2 oil and so would every other consumer out there, particularly those in the third world.  Would our standard of living increase or decrease with $2 oil?

 

If I was Yellen, I would immediately contact my Chinese, ECB and Japanese counterparts and mount an operation to prop up the price of oil

 

Implementing price controls?....  hmmm beside not having the faintest clue as to how a central bank would do this, I wonder if that would make the problem better or worse.  Do we have any other Soviet/Chinese methods to prop up falling oil prices?

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Deflation is not a problem. Debt deflation can be a big problem. They are not the same thing!

+1. If you ask most people why deflation is bad they give you the same look as if you asked them why they believe in dinosaurs.

 

I do agree with Cardboard that low oil prices are beginning to be have deeper negative effects. While there's a fair argument that $65 oil is better for the economy than $100 dollar, $33 oil presents a lot of difficulties around the world. At the least, it seems like a good time to cap off the strategic petroleum reserves.

 

I would love to hear the argument that $65 oil is better for the economy than $33 oil.  Personally, I would prefer $2 oil and so would every other consumer out there, particularly those in the third world.  Would our standard of living increase or decrease with $2 oil?

 

If I was Yellen, I would immediately contact my Chinese, ECB and Japanese counterparts and mount an operation to prop up the price of oil

 

Implementing price controls?....  hmmm beside not having the faintest clue as to how a central bank would do this, I wonder if that would make the problem better or worse.  Do we have any other Soviet/Chinese methods to prop up falling oil prices?

 

Humanity would clearly be better off with $2 oil over the long term.  Although it would be a huge problem for many existing companies and a few entire countries.  It is the same argument that says robots are bad because they cause unemployment.  They are bad for you if you are a factory worker who loses his job, but they make everyone richer long term.  $2 oil would mean either the abiotic oil theory was true and we found a way to easily tap into almost unlimited renewable oil within the Earth, we found a way to turn something else into oil cheaply, or we've transitioned away to another energy supply which is so cheap that there is no demand for oil costing more than $2/barrel.  Deflation of prices = progress.  It means a greater number of people can afford a greater number of things with less work.  It means human beings accelerate our climb up Maslow's hierarchy of needs en masse.  Any other view is the result of short term thinking.

 

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Yeah, if everything was free then nobody would have to work. Why not your milk, car, even your house? What would give you a kick in the ass in the morning to do something? Communism anyone?

 

My point was all about fair pricing which means a balance between supply and demand. It is also about trying to reduce financial manipulations and dislocations that create true problems on Main Street.

 

I am all about the truth and free markets. However, I am against a manipulative media, bear raids, crooks, corrupt governments. I don't think we have to go that far to prove that bear raids can destroy companies and even the entire financial system.

 

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Yeah, if everything was free then nobody would have to work. Why not your milk, car, even your house? What would give you a kick in the ass in the morning to do something? Communism anyone?

 

My point was all about fair pricing which means a balance between supply and demand. It is also about trying to reduce financial manipulations and dislocations that create true problems on Main Street.

 

I am all about the truth and free markets. However, I am against a manipulative media, bear raids, crooks, corrupt governments. I don't think we have to go that far to prove that bear raids can destroy companies and even the entire financial system.

 

Cardboard

 

In that case I misunderstood you.  I thought you were arguing *for* government intervention in the oil price. 

 

My personal view is that the balancing price for oil is probably around the $40 mark but that it needs to spend a while at $30 to get there.

 

I also don't see deflation as a problem, nor do I see oil as being at the root of deflation.

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My point was all about fair pricing which means a balance between supply and demand. It is also about trying to reduce financial manipulations and dislocations that create true problems on Main Street.

 

I agree with that.  If there is a balance between supply and demand and the price is lower it is a good thing (even if some companies/countries/people suffer).  The problem with oil is that it isn't a free market.  You have an industry where some of the largest players are governments, there is always all kinds of manipulation going on.

 

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My point was all about fair pricing which means a balance between supply and demand. It is also about trying to reduce financial manipulations and dislocations that create true problems on Main Street.

 

I agree with that.  If there is a balance between supply and demand and the price is lower it is a good thing (even if some companies/countries/people suffer).  The problem with oil is that it isn't a free market.  You have an industry where some of the largest players are governments, there is always all kinds of manipulation going on.

 

I'd argue that manipulation can't overcome the market in the long run.

 

I also question why this conversation is happening at $30 oil but didn't at $100-120 oil.  The marginal cost of oil was never that high, but I didn't see people complaining about market manipulation then.

 

The simple fact is that when you overbuild productive capacity you need prices to fall *below* the marginal cost of new capacity to balance the market.  I am not surprised that oil is down here - but I'll be surprised if it stays here permanently.

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If I was Yellen, I would immediately contact my Chinese, ECB and Japanese counterparts and mount an operation to prop up the price of oil or at least remove the short punch bowl from Goldman Sachs and some others. I would also call Obama and ask him wtf he is up to with the Saudis.

 

This never ending decline in the price of oil is very negative for many reasons:

 

1- Can`t normalize interest rates. With zero inflation or no fear of it, it is very hard to increase interest rates to a more normal level. With the oil price being so weak, everyone fears that something is wrong and we are at 5.0% unemployment!!!

 

2- This low oil price is going to make S&P earnings negative for the first time since 2008. The implications cannot be clearer: when S&P earnings go down, the S&P has a really hard time staying up which is at some point bad for the economy: wealth effect, fear, etc.

 

3- The longer this continues, the more bankruptcies there will be related to the oil patch. A junk bond panic is not a desirable outcome IMO. While I favour market forces to sort out what is viable and what is not, a 2008 style crisis and the risk of contagion to other markets is not good for anyone.

 

4- Despite strong consumption, with oil being this low you cannot but, wonder if China is about to enter some kind of calamity. If oil was to only go back to $40, a lot of fear would be removed from the Chinese stock market giving them time for their own wealth effect to workout and help their transition away from an entirely export driven economy.

 

5- $40 or $50 oil won`t bring any new supply. You may get some uncompleted wells being put on stream but, there will be no gold rush whatsoever and with what has been cancelled already in the $100`s of billions and decline rates, supply should still come down.

 

As you may guess, I have a vested interest in oil going higher from here. At the same time, I have a vested interest in this World not self destructing itself because of some greedy short idiots or some other conspiration going on (bankrupting Russia?). Moreover, the creation of a massive supply crunch 2 years down the road is going to really hurt the global economy.

 

We are starting to see the unintended consequences of a collapsing oil price. I think that stability is required here and that $60 oil is a desirable outcome: no supply crunch, no depression.

 

Cardboard

 

I mean no offence, but this just seems like a bitter rant from someone who has been wrong on oil and has lost a lot of money doing so (I could be wrong, but am I?). Central banks should come together to "prop up" oil? Really?

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My point was all about fair pricing which means a balance between supply and demand. It is also about trying to reduce financial manipulations and dislocations that create true problems on Main Street.

 

I agree with that.  If there is a balance between supply and demand and the price is lower it is a good thing (even if some companies/countries/people suffer).  The problem with oil is that it isn't a free market.  You have an industry where some of the largest players are governments, there is always all kinds of manipulation going on.

 

I'd argue that manipulation can't overcome the market in the long run.

 

I also question why this conversation is happening at $30 oil but didn't at $100-120 oil.  The marginal cost of oil was never that high, but I didn't see people complaining about market manipulation then.

 

The simple fact is that when you overbuild productive capacity you need prices to fall *below* the marginal cost of new capacity to balance the market.  I am not surprised that oil is down here - but I'll be surprised if it stays here permanently.

 

Well articulated. 

 

Capacity will get shut down, or not bought on line, ever faster as the price tanks.  We dont know what the price is to add capacity, but suffice to say much of the oil drilled in the past few years wont be drilled at these prices.  If the MidEast is at capacity ( accounting for additions and deletions according to political events),  and Russia is at capacity, the US, Can., and everyone else is cutting development then at some point demand will equal or exceed supply.  Probably it overshoots the opposite way, or Maybe I am full of it and am just talking 20-25% of my book. 

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My point was all about fair pricing which means a balance between supply and demand. It is also about trying to reduce financial manipulations and dislocations that create true problems on Main Street.

 

I agree with that.  If there is a balance between supply and demand and the price is lower it is a good thing (even if some companies/countries/people suffer).  The problem with oil is that it isn't a free market.  You have an industry where some of the largest players are governments, there is always all kinds of manipulation going on.

 

I'd argue that manipulation can't overcome the market in the long run.

 

Of course not, but in the short term manipulation can cause all kinds of havoc.  The best way to think of the market is that it is analogous to a TCP/IP network like the internet and government interference is analogous to damage to the network.  It might slow things down a bit, but the network is able to route around the damage.

 

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My point was all about fair pricing which means a balance between supply and demand. It is also about trying to reduce financial manipulations and dislocations that create true problems on Main Street.

 

I agree with that.  If there is a balance between supply and demand and the price is lower it is a good thing (even if some companies/countries/people suffer).  The problem with oil is that it isn't a free market.  You have an industry where some of the largest players are governments, there is always all kinds of manipulation going on.

 

I'd argue that manipulation can't overcome the market in the long run.

 

I also question why this conversation is happening at $30 oil but didn't at $100-120 oil.  The marginal cost of oil was never that high, but I didn't see people complaining about market manipulation then.

 

The simple fact is that when you overbuild productive capacity you need prices to fall *below* the marginal cost of new capacity to balance the market.  I am not surprised that oil is down here - but I'll be surprised if it stays here permanently.

 

Well articulated. 

 

Capacity will get shut down, or not bought on line, ever faster as the price tanks.  We dont know what the price is to add capacity, but suffice to say much of the oil drilled in the past few years wont be drilled at these prices.  If the MidEast is at capacity ( accounting for additions and deletions according to political events),  and Russia is at capacity, the US, Can., and everyone else is cutting development then at some point demand will equal or exceed supply.  Probably it overshoots the opposite way, or Maybe I am full of it and am just talking 20-25% of my book.

 

I think you're right but I don't have the confidence to put 20% of my book behind the thesis.  So far all I have done is initiate a starter position in Cheniere which is probably cheap if oil doesn't pick up and is very cheap if it does.  And by luck or judgement I waited for low $30s oil to start that position last week.

 

What gives me pause is that when the air comes out of a bubble it takes a lot of costs with it.  Salaries that were inflated deflate, margins that were elevated fall, commodity inputs shrink, and the focus on efficiency rises.  As a result the marginal cost can move *dramatically* downwards.  We saw that in north American shale gas.  I don't think oil will go the same way (down, down, down) because the new sources of supply are 5-10% of global supply whereas in north American gas they were much bigger.  But it is a risk that the marginal cost will fall sharply in this scenario and we don't know where it will stop.  My guess is somewhere around $40, but it's an informed guess only.

 

 

 

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My point was all about fair pricing which means a balance between supply and demand. It is also about trying to reduce financial manipulations and dislocations that create true problems on Main Street.

 

I agree with that.  If there is a balance between supply and demand and the price is lower it is a good thing (even if some companies/countries/people suffer).  The problem with oil is that it isn't a free market.  You have an industry where some of the largest players are governments, there is always all kinds of manipulation going on.

 

I'd argue that manipulation can't overcome the market in the long run.

 

Of course not, but in the short term manipulation can cause all kinds of havoc.  The best way to think of the market is that it is analogous to a TCP/IP network like the internet and government interference is analogous to damage to the network.  It might slow things down a bit, but the network is able to route around the damage.

 

I agree, and that's a very good analogy. 

 

As an aside, I'm not sure oil is a more manipulated market than most others.  For example, you might say Saudi and OPEC "manipulate" the price of oil.  I might contest that, arguing that they are pumping everything they can because they are the lowest cost producer, which is exactly what the free market wants them to do.  But even if I accepted your argument, at least they *produce* oil.  Absolutely all other markets on earth are being rigged, sometimes, blatantly, by government agencies that produce nothing but electronic money according to academic (but largely untested) theories of how much there should be.  I object to that rather more than I object to a few oil producers getting together and running an ineffective cartel ;)

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That's assuming the lower energy costs are a bad thing.

 

Perhaps...

Less money spent heating homes, driving cars, and shipping goods around the world may lead to increased spending by consumers...

 

 

Thinking about this some more and while I agree with what you've said, there might be another factor at play.

 

As commodity prices rise they attract speculators.  Hedge funds, oil etfs, people storing oil.  In a low rate environment, many of these players use leverage.  Companies throughout the supply chain also leverage up.  In other words rising commodity prices drive money creation via credit creation.  That money ends up in the pockets of the low cost producers like the Saudis who go and buy stocks and art and houses in nice cities, causing asset bubbles that make everyone feel richer (simplifying a bit here but hey!).

 

When all that unwinds it is true that consumers feel swell because gas (or petrol, as we say in English ;)) costs less at the pumps.  But is that enough to overcome the deflationary effects of credit (and therefore money) destruction?

 

I'm thinking out loud here but I suspect that this commodity supercycle has been one of the most leveraged in history (because rates are at historic lows).  That might change the ratio between the positive effects (richer consumers) and the negative effects (credit destruction, asset deflation) of falling commodity prices.

 

I'm firmly of the opinion that tighter money and less credit would be a good thing long term so I'm not saying that central banks should manipulate commodity prices up.  But using this framework I can see how falling commodity prices might be a bad thing, temporarily, for GDP statistics and whatnot. 

 

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