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Musings Report #48 11-29-14 The Oil-Drenched Black Swan
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The Oil-Drenched Black Swan
The sharp decline in the price of oil will have a profound impact on the global economy, in ways that qualify it as a "black swan": an unexpected outlier that triggers vast unforeseen consequences--some positive, but more negative.
Of the many remarkable points about this collapse from $106/barrel to $68/barrel in a few months (a 36% drop), the first is how the enormous army of conventional economists and forecasters completely missed the collapse and its dire consequences for global financial markets. How could something as well-studied as the global oil market surprise us?
There's a certain irony in the chaos being unleashed by a decline in the price of oil: for years, the consensus has been (and remains so) that declining oil costs are an unmitigated good for consuming nations, as the drop in price effectively boosts disposable income: the $100/month a household saves as the price of gasoline drops can then be spent on other goods and services.
But instead of growth, the decline is a falling domino that is triggering "risk-off" disruptions that will speed the global economy's slide into recession.
This is very different from the usual dynamic of oil and recession. In the past, recessions were triggered by oil spiking high enough to crimp consumer spending. This drop in spending (and borrowing to spend) pushes the economy into recession.
This time, the drop in oil is destabilizing the global economy in ways that have nothing to do with household cash.
The conventional economists who are crowing about the decline as a positive are overlooking a number of key dynamics:
1. In terms of consumers gaining disposable income, the effect is underwhelming for a number of reasons.
-- The amount of oil per unit of GDP has dropped sharply since the 1970s. Oil plays a smaller role in the economy than in previous decades, and so a drop in price isn't as significant as assumed.
-- Consumption has been declining for demographic reasons: as the populace ages, people drive less. The younger generations are not enamored of living in distant suburbs or owning cars.
-- Most of the cost of fuel in Japan and Europe is taxes, so the decline in oil as a percentage of the cost of fuel is modest.
-- Households may not spend the "extra money" gained from declining fuel costs; given the stagnation in wages and the rising costs of taxes, fees and services, they may choose to save the money, use it to pay down credit cards, etc.
This desire to conserve cash will increase as fear of recession takes hold.
2. The forecasters focusing on the consumption side are missing the catastrophic consequences of the sharp drop on the supply side.
The decline in net income is much larger than the decline in the price of oil. Suppose the cost of production is $50/barrel. At $105/brl, the producers are netting $55/brl. If the price drops to $65/brl, the net plummets to $15/brl--a crushing 70% drop in net profits.
-- The drop will devastate national income in oil-revenue dependent states such as Venezuela, Iran, Russia and the Gulf states.
-- This collapse of income will push some governments into bankruptcy, as the state will be unable to pay its bondholders the interest due on sovereign bonds. The knock-on effects of this default will be swift and severe.
The Venezuelan currency, which has been sliding for months, will implode, impoverishing the populace that depends heavily on imports.
-- The possibility that the price drop will push U.S. producers into insolvency has been covered in the blogosphere. At a minimum, it will push profits and employment down, and cause development of new projects to be put on hold.
3. Forecasters are also blind to the psychological consequences of the destabilization of oil-producing economies and currencies. All the "risk-on" trades that have been viewed as safe for the past 6 years will be unwound as the mood shifts from "risk-on" complacency to "risk-off" fear and caution.
-- Other currencies will be destabilized as the "risk-off" exit from risky assets gathers steam. Even currencies that are little impacted by oil directly will be sold as capital flows to the safety of dollars, yen, Swiss francs, etc.
These profoundly destabilizing consequences are what qualify this drop as a black swan. Rather than be a "good thing" that fosters more complacency, the drop will unleash a tsunami of "risk-off" instability.
4. The conventional pundits are also blind to the consequences of oil's role in global financial markets. Oil is not just a commodity; it is collateral for loans and many other financial instruments: futures contracts, etc.
Oil's role in global finance has been increasing under the radar of conventional analysts, who are ill-prepared to grasp the domino effect of the sudden drop in collateral and the equally sudden increase in risk.
5. I have been writing about the "Oil Head-Fake" for years. In my view, any sharp decline in cost is a "head-fake" that creates a temporary illusion that oil is plentiful.
But as the costs of production have risen, so has the break-even point: once the price drops below a certain level (the level varies by region, of course), producers are losing money. In response, they cap the wells and postpone development of new fields.
This pushes supply down, which then sets up an oil shock when supply falls below demand. The key to understanding this dynamic is the differing timelines of stopping and restarting production and development: ceasing production and canceling development projects can be done very quickly, but reversing the process takes time.
Projects that are shelved in the head-fake may take years to come online after prices rise back above production costs.
This sets up a rise in oil prices that far exceeds the marginal decline in production. Since the price is set on the margins--the 5% excess in supply or demand--relatively modest declines in supply can trigger outsized leaps in price once demand exceeds supply.
I think the financial markets are highly vulnerable to a black-swan crash in the next few weeks of unexpected depth and intensity. The analysts crowing about "oil as QE 4" stimulus are completely ignoring the global shift from "risk-on" to "risk-off" that this sudden free-fall is unleashing.
As I often observe, risk cannot be disappeared, it can only hidden or transferred to others. Risk pops up where it is least expected. The analogy is plumbing pipes. The joints that have been re-soldered and inspected are not the ones that leak; it's the ones everyone assumed were safe that burst.
Summary of the Blog This Past Week
If You're Giving Gifts, Consider Giving Tools/Skills 11/28/14
My Thanksgiving: Five Things I Am Thankful For 11/27/14
Prosperity Amidst the Ruins 11/26/14
Nothing Has Changed--and That's the Problem 11/25/14
Central Banks: When We Succeed, We Fail 11/24/14
Best Thing That Happened To Me This Week
An international Thanksgiving gathering of friends and new acquaintences from Hong Kong, Moldova, Colombia, Poland, Greece, South Africa and the U.S.
Market Musings: Oil
Here is a chart of crude oil since 2010. The ebb and flow between $85 and $105 reflects the crisis du jour and the return of complacent confidence in central bank-driven global growth.
The lower support has been completely shattered, and while we can anticipate a spike back up to this line at some point, we can also anticipate a failure and a decline to a new low.
This is one of the consequences of oil becoming an increasingly important part of the global financial system. It is not just a commodity, it is leveraged collateral. That makes it icnreasingly prone to financial-type meltdowns triggered by panic selling and insolvencies resulting from counterparties failing.
This financial turmoil will spread quickly as everyone with "risk-on" positions seeks to exit and shift capital to safer "risk-off" assets.
From Left Field
The Meaning of Black Friday -- a bit of history
Black Friday, Through the Eyes of Smith and Marx -- the amazing capability of over-producing junk nobody needs...
how much is a trillion dollars? 63 mile-high stack of $1000 bills
Workers Per Retiree:The Graph That Rebukes The Myth Of Printing Press Prosperity
Beijing Admits $7 Trillion Waste And Theft During “Investment” Spree -- ghost cities and empty airports are not productive...
What Is the Outernet and Is It the Future of the Internet?
'Those Whom a God Wishes to Destroy He First Drives Mad' -- the natural urge to tweak the model to fit the data....
The Program Big Oil's PR Firm Uses to 'Convert Average Citizens' (via Lew G.)
‘The Chain,’ by Ted Genoways - the largely unknown story of Hormel hogs becoming processed food....
A Sustainable Solution for the Corn Belt (via Joel M.)
The Shazam Effect: Record companies are tracking download and search data to predict which new songs will be hits. This has been good for business—but is it bad for music?
Scientists may have cracked the giant Siberian crater mystery -- bad old methane....
A Journey Through The History Of American Food In 100 Bites -- how many have you taken?
"If you have any young friends who aspire to become writers, the second greatest favor you can do them is to present them with copies of 'The Elements of Style'. The first greatest, of course, is to shoot them now, while they’re happy." Dorothy Parker
Thanks for reading--
charles |
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