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

[TwoCitiesCapital]

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.

 

+1

 

When you consider that the majority of GDP growth over the last 5 years was driven by shale states and was flat/negative elsewhere, it's hard to say that falling oil prices will contribute to GDP in any way. Period.

[merkhet]

Unless the multiplier on high commodity prices is lower than the multiplier on low commodity prices...

[rkbabang]

Unless the multiplier on high commodity prices is lower than the multiplier on low commodity prices...

+1,  Would you rather the GDP grow only in the shale states or have low energy prices and have GDP grow everywhere else instead?

 

[ERICOPOLY]

More people work in solar than in oil -- why not let oil do it's thing and increase the subsidies for solar?

 

That's where the jobs are and it's good policy.

 

Solar energy jobs double in 5 years

http://money.cnn.com/2016/01/12/news/economy/solar-energy-job-growth-us-economy/index.html?iid=surge-stack-dom

 

 

[petec]

Unless the multiplier on high commodity prices is lower than the multiplier on low commodity prices...

+1,  Would you rather the GDP grow only in the shale states or have low energy prices and have GDP grow everywhere else instead?

 

Oh - I would *rather* have low energy prices and more balanced GDP.

 

But the point is that if a dollar spent on oil gets leveraged by speculators, producers, service companies, and ultimate owners in the way I have described, then it creates much more than a dollar of global GDP. 

 

When that dollar is taken away from them and stays with a consumer that is currently *de*leveraging (i.e., part of that dollar gets saved) then the GDP created may be less than a dollar.

 

So, while it will be more balanced, the GDP in this scenario will be smaller.  That's my point.

 

Now, if merkhet is right and the multiplier on low commodity prices is higher than the multiplier on high ones then that will partly offset my argument.  I'm not sure what the evidence is on that.

 

Background: as someone who assumed low oil would be good for GDP, I am trying to figure out why that hasn't been the case.  Visa tells us the consumer is saving 75% of the windfall.  So my answer is: if money is coming out of the leveraged commodity complex and being used to delever the consumer, that will bring aggregate GDP down, all else equal, because it brings down aggregate leverage and GDP is very sensitive to credit creation.  I agree the resulting GDP will be better balanced and less levered (good things in my book) but it will also be smaller.

 

[Uccmal]

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.

 

Your last paragraph covers alot of ground.  Salaries in O&G are very high during booms.  As the inputs shrink, the cost of production will go way down in non-state controlled environments.  They already have.  The net is the same.  If/when prices rise the companies get the spread from the efficiencies realized.  There are alot of recent oil workers stuck in Calgary and elsewhere who will gladly take reduced pay.  There was an enormous amount of waste in the system. 

 

I hiked with a guy a few years ago, who worked the fall season for an oil company.  He was trained in advanced first aid (1 week course) and made enough in 12 weeks to live on all year in Canmore Alberta, one of the most expensive towns in Canada.  He sat in a truck all day and read books.  You can bet the first aider now has a real job as well. 

 

In the mideast, they dont have the same elasticity available.  If they cut jobs, or input costs, they get civili unrest, especially since the cuts will come along religious lines.  It is entirely possible in the race to the bottom, the Mideast will lose.  Or they will cry Uncle and cut production enough to bring the price back up.  Either way a "survivor" in NA wins. 

 

Some companies in the Cdn. west are in not terrible shape, and would have access to lots of cash to buy a Pennwest.  As an aside Russel Metals has made it very clear they are looking for bolt on acquisitions - they just purchased a company for "parts" the other day.  It wouldn't surprise me in the least to see Whitecap, or Arc Resources buy Pennwest.  Whitecap is the obvious fit since they operate in the same lease areas.  But I digress, these threads are all so similar. 

[petec]

Just reading Ultra Petroleum's conference call for a bit of fun.

 

They averaged $2.85m to drill a well in the last quarter.  In 2007, that was $6.3m.  Incredible how shale players have taken costs out.

 

Most intriguingly, the $2.85m is down 25% y/y so they have been able (so far) to accelerate the cost-outs as commodities have fallen.

 

Not using this data to prove anything, just think it's interesting.

[merkhet]

I think the reason you haven't seen GDP growth due to lower commodity prices has to do with issues in the housing market. Issues that I believe are beginning to resolve themselves over the next year or two.

[ni-co]

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.

 

+1

Agree with you 100%. By focussing on the price of oil people are barking at the wrong tree. It's a global demand issue caused by the turn in the long-term debt cycle in 2007/2008. Central bankers can and should try to smooth this credit contraction but they can't invert it.

 

[petec]

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.

 

+1

Agree with you 100%. By focussing on the price of oil people are barking at the wrong tree. It's a global demand issue caused by the turn in the long-term debt cycle in 2007/2008. Central bankers can and should try to smooth this credit contraction but they can't inverse it.

 

+2 - hadn't read TCC's post properly but it is outstanding.

[Cardboard]

Some people are a lot crazier than I am:

 

http://money.cnn.com/2016/01/14/investing/oil-bailout-us-washington/index.html?iid=hp-stack-dom

 

Indeed, I would have loved for that f.. Kilduff guy to simply shut up as oil was coming down, as he could not resist always commenting negatively about oil. Probably talking his short book and now he is switched to long...

 

When I mentioned about the Fed to prop up the oil price, I didn't mean a full TARP program. I had more in mind looking at things such as the uptick rule, crazy levered instruments such as UWTI and DWTI that trades $100 millions per day and discovering if abuses are being committed by hedge funds or other firms via the media, futures market or even via the EIA.

 

A market cannot be manipulated indefinitely. In the end, it always revert back to its true supply and demand pricing. However, in the short to medium term, the damage from manipulation to profit from shorting can lead to unnecessary and very real pain on Main Street: job losses, suicides, broken families, etc. Don't get me wrong, I also believe that manipulating on the upside is also wrong and has lead to some of what we are experiencing.

 

And if you were to watch the business media at all, you could and still can clearly see a link being made between oil and stock markets, economies, likely leading to a negative feedback loop. If you think this is too far fetched, then I believe that some countries going belly up such as Venezuela and causing more fear and seizing up of credit in the emerging market asset class is a tangible risk.

 

The game has now been setup for a supply crunch in a few years instead of a more normal production adjustment that would have occurred at $50 or even $60 oil. The latter was likely what the Saudis had envisioned back in November 2014. Now these guys will also have to endure a lot of unintended consequences from their acts.

 

Cardboard

[petec]

Some people are a lot crazier than I am:

 

http://money.cnn.com/2016/01/14/investing/oil-bailout-us-washington/index.html?iid=hp-stack-dom

 

Indeed, I would have loved for that f.. Kilduff guy to simply shut up as oil was coming down, as he could not resist always commenting negatively about oil. Probably talking his short book and now he is switched to long...

 

When I mentioned about the Fed to prop up the oil price, I didn't mean a full TARP program. I had more in mind looking at things such as the uptick rule, crazy levered instruments such as UWTI and DWTI that trades $100 millions per day and discovering if abuses are being committed by hedge funds or other firms via the media, futures market or even via the EIA.

 

A market cannot be manipulated indefinitely. In the end, it always revert back to its true supply and demand pricing. However, in the short to medium term, the damage from manipulation to profit from shorting can lead to unnecessary and very real pain on Main Street: job losses, suicides, broken families, etc. Don't get me wrong, I also believe that manipulating on the upside is also wrong and has lead to some of what we are experiencing.

 

And if you were to watch the business media at all, you could and still can clearly see a link being made between oil and stock markets, economies, likely leading to a negative feedback loop. If you think this is too far fetched, then I believe that some countries going belly up such as Venezuela and causing more fear and seizing up of credit in the emerging market asset class is a tangible risk.

 

The game has now been setup for a supply crunch in a few years instead of a more normal production adjustment that would have occurred at $50 or even $60 oil. The latter was likely what the Saudis had envisioned back in November 2014. Now these guys will also have to endure a lot of unintended consequences from their acts.

 

Cardboard

 

I don't disagree with most of what you have written, but I see it differently.  As usually happens in commodity supercycles (and there have been a few) oil stayed way above the cost of marginal capacity for several years.  Excess capacity was created, and therefore oil has to go way below the marginal cost for a while to bring the market to balance.  In other words, I am not surprised oil is here and I don't think it's the result of manipulation*, I think it's the result of market forces.  Now, I am sure a lot of trades get made around these moves and you may call those manipulation - but I think the current price is fundamentally justifiable for a period of time.

 

*well, I do think it is the result of manipulation - but only in the sense that $110 oil was the result of an easy-money bubble and $30 oil is the consequence of $110 oil given that the marginal cost was probably around $70 at the peak and capacity got overbuilt (by a lot, when you consider that the marginal cost is likely falling to $40-50 as the bubble deflates).  All bubbles overcorrect.  You want to pin those suicides on anyone, I'd look at the Fed for blowing the bubble in the first place.

 

Just my thoughts!

 

P

[JayGatsby]

+1

Agree with you 100%. By focussing on the price of oil people are barking at the wrong tree. It's a global demand issue caused by the turn in the long-term debt cycle in 2007/2008. Central bankers can and should try to smooth this credit contraction but they can't invert it.

Hasn't demand continued to increase? Seems like cheap easy credit created excess supply (in all materials, not just oil), not that a lack of credit created a lack of demand?

[Uccmal]

Some people are a lot crazier than I am:

 

http://money.cnn.com/2016/01/14/investing/oil-bailout-us-washington/index.html?iid=hp-stack-dom

 

Indeed, I would have loved for that f.. Kilduff guy to simply shut up as oil was coming down, as he could not resist always commenting negatively about oil. Probably talking his short book and now he is switched to long...

 

When I mentioned about the Fed to prop up the oil price, I didn't mean a full TARP program. I had more in mind looking at things such as the uptick rule, crazy levered instruments such as UWTI and DWTI that trades $100 millions per day and discovering if abuses are being committed by hedge funds or other firms via the media, futures market or even via the EIA.

 

A market cannot be manipulated indefinitely. In the end, it always revert back to its true supply and demand pricing. However, in the short to medium term, the damage from manipulation to profit from shorting can lead to unnecessary and very real pain on Main Street: job losses, suicides, broken families, etc. Don't get me wrong, I also believe that manipulating on the upside is also wrong and has lead to some of what we are experiencing.

 

And if you were to watch the business media at all, you could and still can clearly see a link being made between oil and stock markets, economies, likely leading to a negative feedback loop. If you think this is too far fetched, then I believe that some countries going belly up such as Venezuela and causing more fear and seizing up of credit in the emerging market asset class is a tangible risk.

 

The game has now been setup for a supply crunch in a few years instead of a more normal production adjustment that would have occurred at $50 or even $60 oil. The latter was likely what the Saudis had envisioned back in November 2014. Now these guys will also have to endure a lot of unintended consequences from their acts.

 

Cardboard

 

I don't disagree with most of what you have written, but I see it differently.  As usually happens in commodity supercycles (and there have been a few) oil stayed way above the cost of marginal capacity for several years.  Excess capacity was created, and therefore oil has to go way below the marginal cost for a while to bring the market to balance.  In other words, I am not surprised oil is here and I don't think it's the result of manipulation*, I think it's the result of market forces.  Now, I am sure a lot of trades get made around these moves and you may call those manipulation - but I think the current price is fundamentally justifiable for a period of time.

 

*well, I do think it is the result of manipulation - but only in the sense that $110 oil was the result of an easy-money bubble and $30 oil is the consequence of $110 oil given that the marginal cost was probably around $70 at the peak and capacity got overbuilt (by a lot, when you consider that the marginal cost is likely falling to $40-50 as the bubble deflates).  All bubbles overcorrect.  You want to pin those suicides on anyone, I'd look at the Fed for blowing the bubble in the first place.

 

Just my thoughts!

 

P

 

Pete, what you say makes sense. 

 

Aside from the recent calls by Soros, Goldman, and MStanley, I dont see any "unusual" manipulation.  Anyone stupid enough to ba counterparty to GS deserves what they get.

 

I think we wait it out.  There is a point somewhere at which this starts to get absurd. We are now at the lowest Inflation adjusted price since the plummet in 1998, and below alot of the 1990s pricing.

 

Today is reflecting the extra holiday in the US.  No one wants to be caught holding the ball over a long weekend. 

[Libs]

+1

Agree with you 100%. By focussing on the price of oil people are barking at the wrong tree. It's a global demand issue caused by the turn in the long-term debt cycle in 2007/2008. Central bankers can and should try to smooth this credit contraction but they can't invert it.

Hasn't demand continued to increase? Seems like cheap easy credit created excess supply (in all materials, not just oil), not that a lack of credit created a lack of demand?

 

Demand is down over the last 5 years in the  US, Europe, and Japan combined. It's only up in the aggregate because of the rest of the world. If China (and other EM's) rolls over and demand drops off there, aggregate demand will probably drop. No one is expecting this, but if it happens, look out. The oversupply problem will be far worse than expected.