The late Dr. Rudiger Dornbusch was an economist at the Massachussets Institute of Technology and was often the cause of headlines for his rather outspoken views on crises in emerging markets, especially as they related to currency exchange rate movements. He was almost alone in predicting the Mexican Peso crisis of 1994 and that too just weeks before the Peso collapsed. Now, I admit to being no better aware of his work today as I was then. But there was a moment of insight when I came upon this quote attributed to him
“A Crisis takes a much longer time coming than you think and then it happens much faster than you would have thought”
That was an “a-ha!” moment and hardly would it have been one if not for the fact that I’d just come out of a 2 hour session reading up on the phenomenal slump in global oil prices. A little backgrounder first – For the past 3 years or so and even before the recent crash, Crude prices were holding up around the $ 100 per barrel mark. It had touched a high of $ 147 in 2008 (only to fall thereafter for a short while) but even at $ 100 per barrel, Oil was considered expensive relative to the $ 20-40 range that persisted for more than a decade. And then, prices started cratering, falling over 48% in 2014 settling in at around $ 48 per barrel as of this writing.
I’ll completely admit to being caught off guard by the crash in prices of this commodity, one about which I certainly have no unique insight. But it is indeed a great place to start thinking of events – related or isolated that may have underpinned the crash and what they might have in store. Of course, I’ll clearly stay away from forecasting about the right price of Oil. For one, even experts aren’t good at predicting prices. Oil markets have a multitude of variables impacting in conjunction –economic, financial markets, geopolitics, technology and geology to cite a just few.
Within or Beyond Fundamentals
None better a place to start with than demand /supply. Conventional wisdom does that demand has been moderating over time. And what may have predicated that ? The emergence of alternative energy sources and hydrocarbon efficiencies figure in the list of structural drivers. True – they’re both relevant. But alternative energy accounts for a rather small pie (just 9.5% of US energy consumption) and is at best a developed market game changer. Hydrocarbon efficiency is quite the phenomenon though. The US today for instance, produces a Dollar of GDP with less than half the oil & gas it required 20-30 years earlier and emerging markets have leapfrogged in their adoption. But I believe that neither had the potential to drastically alter demand in the course of a year. Search for immediate cause and effect leads us to poor performance of the global economy. Japan is back in recession mode after a brief surge, technicalities are the only thing standing in the way of the Eurozone and a recession and finally, the Chinese machine is sputtering at a much slower pace than ever. Having expanded at 10-12% in real terms just a year ago, even 7% looks tough to sustain in the present. Marketwatch columnist Craig Stephen gets to the core on China when he says
“The oil market is unlikely to find another country or even a continent that can take over this degree of heavy lifting in demand growth….In the past, demand appeared inelastic as growth continued even as crude prices reached triple digits. But this period coincided with state funded industry being the dominant driver, whereas demand for gasoline for cars can be expected to be dependent on the income growth of the middle class.”
The supply equation needs less explanation. According to estimates, the world has about 2.5 mbpd (million barrels per day) of excess supply. Well, I always thought OPEC or the popular oil cartel would come in to save the day but they’ve been rather quiescent this time around. Contrary to expectations, OPEC decided in late November to maintain their production target. And so, despite ISIL (or whatever name it goes by this week), Iraq, Libya, the Russian crisis, and scandals galore in Brazil – all of which can affect production, the supply demand balance remains ample. And yet, it needs to be pointed out that excess supply has only grown from 1-1.5 mbpd to about 2.5 mbpd. It looks like neither demand nor supply dynamics can take blame for the dramatic tightening of the oil market.
Geopolitics and Conspiracy Themed Stories
In the midst of this analysis centred on demand and supply, it is easy to forget that Oil is a complicated commodity and a plunge of the sort that we’ve witnessed is more likely to throw up conflicting theories and messages. The geopolitical context has cascaded with conspiracy theories and stories of the sort. In my view, some of them might have enough firepower to be touted in popular media as conventional wisdom. A couple of the prominent ones are worth sampling.
- Despite the oversupply of oil, OPEC nations led primarily by Saudi Arabia have not cut production. First, they wish to wage an economic war on Russia and Iran. Remember, the relationship between Saudi’s and Iran can be described as adversarial at best. Also, both the Iranian and Assad regime in Syria have Russian backing. Juxtapose this with the unfortunate circumstance that both Russia and Iran are highly dependent on oil revenues to balance their budgets. According to sources, Russia requires a Brent crude price of approximately $ 105 per barrel while Iran does no good until oil hits over $ 140 per barrel. Do we have a story taking shape here? And the Saudi’s (for good measure the US as well) may have an ace up their sleeve here. The Rouble had an unforgettable year in 2014, plunging against the US Dollar. Adding insult to injury, the Russian central bank had to abandon a peg to the dollar in November 2014 and ended up blowing a $ 70 billion hole in their reserves to defend the Rouble.
- The Saudi Arabia wishes to maintain market share of global oil supply and therefore will have to eliminate some of the new production that has come online in recent years. More specifically, the Saudi’s will have to eliminate or make life difficult for the US shale producers. As things stand now, it is significantly cheaper to produce oil from the onshore fields of the Middle East than it is to extract oil from the North American shale plays. In addition, the Saudi’s also have a little support from Geology – US shale producers have to contend with exceptionally high decline rates while a single oil field in the Middle East like the Ghawar oil field has been pumping for over 60 years. And here’s the redeeming part – the strategy appears to have again paid off for the Saudi’s. It does look like quite many shale producers are essentially being kept afloat due to their ability to easily access credit markets and issue high yield debt. But as commentators like Raúl Ilargi Meijer of The Automatic Earth report, the North American shale producers will have a hard time rolling over the high yield debt at earlier interest rates.
While on the subject of conspiracy theories, here’s a caveat – Just because they’re labelled so does not mean that there’s no strength in them. Indeed, anxieties usually based on geopolitical considerations can be one among many triggers for sudden and dramatic price moves, including this recent one. In their book Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism, George Akerloff and Robert Shiller make compelling arguments for the position that traditional economic models based on rational actors and perfect markets cannot explain the economic crises we currently face. According to Akerloff and Shiller, economists tend to avoid basing their analysis on stories – it is unprofessional to use anecdote rather than quantitative analysis. But they make a very interesting observation that is significant in the context we’re on
“But what if the stories themselves move markets? What if these stories of over explanation have real effects? What if they themselves are a real part of how the economy functions ? Then economists have gone overboard. The stories no longer explain the facts. They are the facts.”
Indeed, the behavioural economists probably are right on the button in this case as well. As some of the above theories gain ground, what many fail to point out is that a contrarian move is getting lost in the shuffle. That relative to earlier times, Saudi Arabia is today the global champion of free market pricing for oil while American oil companies and the mainstream media clamour for OPEC to renew their commitment on price rigging. Until mid 2014, the Saudi’s were the swing producers, restricting supply when called for in order to maintain a high price. But the same regime proved an ideal ground for US and Canadian oil producers to hike up production sharply. In fact, there is no doubt that such production would have only made sense at higher levels of pricing and so ironically we had a situation when the Saudi’s helped fuel profits of North American producers. But by September of 2014, the Saudi’s and OPEC were well into realizing that the resulting supply dynamics had changed status quo – that they would no longer be able to maintain a high price for oil by simply controlling their own output. Indeed, reducing output would be a losing strategy as it would only make more room in the market for North American producers. The Saudi’s in fact had lessons from their own history that in the end may have been more powerful than any geopolitical incentive. Back in the 1980’s, they were the one’s maintaining oil prices by cutting production. But the output cuts and high prices prompted a counter reaction. Over the next 5 years, global oil consumption fell by 6 mbpd and supply grew by 7 mbpd. To maintain prices, the kingdom was forced into successive rounds of production cuts and from 10 mbpd in 1980, Saudi production fell to just 3.4 mbpd in 1985. Faced with the prospect of irreversible losses and a 20% fall in GDP, Saudi Arabia and OPEC abandoned the strategy and oil prices collapsed in 1985. They would gradually claw back production but those levels would not be revisited until 2005.
Central Banks, QE and Currency Wars
So, we still haven’t been able to point a finger at someone or something and lay the matter to rest. Lacking obvious culprits, there’s merit in riding up to many doorsteps in the hope of finding one. Financial markets for one have to figure in the scheme somewhere. I’ve been a regular reader of the Absolute Return Newsletter, a great commentary by Niels.C.Jensen. Here’s an interesting comment in the January 2015 letter
“When interest rates are managed (some say manipulated), markets are efficient enough to make the necessary adjustments elsewhere and, in this context currencies play an important role”
“A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spill over across borders, sometimes through a weaker exchange rate. “
There is no doubt that the Federal Reserve’s QE policy has influenced markets across the board. Since the adoption of the first phase of Quantitative Easing or QE in 2009, the balance sheets of the US Fed and Bank of England have each expanded four times while that of the ECB has doubled. While ostensibly the adoption of QE is intended to counter deflationary pressure and stimulate an economic revival, the discernible impact has however been a weakening of the currency. Supporting this has been the flow of capital to foreign markets in search of higher returns and yields on risk assets. Interestingly what both Rajan and Jensen allude to is that low interest rates are only part of the picture. Without the exchange rate impact of QE – lower for the US Dollar, there may not have been much of an effect at all. Now, when a significant portion of global central bank QE effect is pushed through the exchange rate channel, there are bound to be implications for assets that are priced in Dollar terms, especially commodities. A decline of the Dollar caused commodities to become less expensive in non Dollar terms, thereby stimulating their demand in non Dollar countries. And a rise in demand for commodities finally feeds back into a price increase in Dollar terms. Granted that there are fundamental forces at work here but there is no doubt that changes in value of the reserve currency has accentuated the price movement in commodities, especially Oil. Indeed, the US Fed and other central banks have been waging a new age currency war. Speaking at Davos 2015, Gary.D.Cohn, the President & COO of Goldman Sachs USA had this to say “We’re in a currency war. One of the easier ways to stimulate your economy is to weaken your currency”
Listening to Minsky
If we are to describe the crisis response of QE since 2009 as a “favourable shock” or “displacement”, the set up is complete for a Minsky Bubble. This is one subject that I’d surely want to write about again but for now, it would do us all a measure of good to reference the late Charles Kindleberger’s observations, drawing on the excellent work of Hyman Minsky.
“Minsky suggested that the events that led to a crisis start with a displacement or innovation, some exogeneous shock to the macroeconomic system. If the shock was sufficiently large and pervasive, the anticipated profit opportunities improve in at least one important sector of the economy: the profit share of GDP increases”
And there we have a familiar story: As QE held down the value of the US Dollar and stimulated commodity demand leading finally to a sustained rally in oil prices, US Shale production became possible or at least more profitable. As highlighted earlier, most analysts believe that the marginal cost of production for US Shale is over $ 100 per barrel. At any rate, it is not cheap to produce and QE surely made more wells profitable.
“The boom of the Minsky model is fuelled by the expansion of credit. Minsky noted that ‘euphoria might develop at this stage. Investors buy goods and securities to profit from the capital gains associated with the anticipated increase in their prices. The authorities recognize that something exceptional is happening and while they are mindful of earlier manias, ‘this time is different’ and they have extensive explanations for the difference”
“A follow the leader process develops as firms and households see that speculators are making a lot of money. There is nothing as disturbing to one’s well being and judgement as to see a friend get rich. Unless it is to see a non friend get rich. Investors rush to get on the train even as it accelerates.”
“The end of a period of rising asset values leads to distress whenever a significant number of investors have based their purchases of these assets on the anticipation that the prices will continue to increase. Some investors continue to hold the assets because they believe hat the price decline is temporary, a hiccup. The prices of the securities may increase again, at least for a while. More and more investors realize that prices are unlikely to increase and that they should sell before a further decline; In some cases the realization occurs gradually and in others suddenly. The race into money may turn into a stamped. The rush is on. “
Wolf Richter draws a clear perspective in this post that reflects the truth in Minsky’s observations. Given the simplicity of his thesis, the wonder is that he was ignored for so long. Perhaps it was the simplicity itself that hindered the rise to prominence of his work among economists of his generation. But as the roller coaster ride that is oil prices tops all thrills for now, Minsky does seem to be having another Moment.
The last week has been flush with commentary about Greece and what is to follow in the Eurozone. I’ve had quite some reports to read up on and a few good European friends in the bond markets have been helping me decipher the repercussions of the moves at play. I hope to have an interesting post coming your way on the subject soon. Meanwhile, If you enjoyed this post, I’d be very grateful if you’d help it spread by emailing it to a friend, or sharing it on Twitter or Facebook. Thank you!