Oil Economics, Part 2, by Robert Gore

Monday’s post, “Oil Ushers in the Depression,” was one of the most read, commented on, and controversial posts on SLL. Here is an amplification, and a doubling down on the prediction in that piece:

The sharp drop in oil will support U.S. growth by boosting spending, two top Federal Reserve officials said, playing down the risk that plunging energy costs could push inflation further below the Fed’s goal.

Fed Vice Chairman Stanley Fischer and New York Fed President William C. Dudley, speaking at separate events today in New York, both stressed the positive impact on the U.S. economy from the steepest decline in oil prices for five years.(Bloomberg, “Fed’s Dudley Says Oil Price Decline Will Strengthen U.S. Economic Recovery,” 12/1/14)

If that sounds eerily like Benjamin Bernanke’s infamous assurance that “…the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,” it should (testimony before the Joint Economic Committee, U.S. Congress, 3/28/07). However, Fischer and Dudley go Bernanke one better. Bernanke at least acknowledged a problem, although he woefully underestimated its impact. The dynamic duo sees nothing but blue skies after oil’s precipitous fall. Their Panglossian visions reveal the rotten-to-the-core premise of Keynesian economics and complete ignorance of the towering debt skyscraper of cards their policies have helped erect.

In their Keynesian world, demand and consumption are the center of the solar system around which all other economic factors revolve. Reality, on the other hand, dictates that something must be produced before it is consumed, so we’ll stick with reality-based economics. Fischer and Dudley don’t even acknowledge that the falling price of oil might harm producers.

The Saudis are the world’s low cost producer. It is much cheaper to pump oil out of the desert than it is to frack it, extract it from tar sands or shale, or pump it from under the ocean, which is how oil is produced in much of the rest of the world. The Saudis amortized the costs of their petroleum industry long ago; the relevant cost to them is their marginal cost.They have decided to pump sufficient oil to drive its price low enough to make it uneconomic for many higher-cost producers to produce.

Their decision has political and economic motivations. The Saudis have been mightily displeased by the course of events in Syria. The Sunni Saudis don’t like Shiite Bashar Assad, Syria’s despot. They thought President Obama would fight their war for them when Assad crossed his red line. They were furious when Vladimir Putin gave Obama a face-saving out, not just because of Obama’s inconstancy, but also because Putin had thwarted a potential US attack against his ally, Assad. The U.S.’s half-hearted response to the Islamic State—its reluctance to put those all important boots on the ground—has further inflamed the Saudis, who view the campaign against the Islamic State as the perfect pretext for getting rid of Assad.

What better way to punish both the US and Russia (and perpetual enemy Shiite Iran), and reestablish dominance in oil, than by glutting the market? As a business plan, taking on debt at junk bond rates to fund oil production, as many US and Canadian producers have done, or basing government budgets and economic projections on a high price of oil, as Russia and many other oil-producing nations’ governments have done, leaves something to be desired when the lowest-cost producer can lay waste to your plan at any time.

The subprime fiasco offers the perfect analogy. Just as everything “worked” as long as house prices kept going up, the dreams in the oil patch seemed plausible when its price was high. As soon as oil’s price headed in the undesired direction in this highly leveraged market, the dreams evaporated, just as they did in the highly leveraged housing market. The debt of the most indebted producers, now losing money, is worth less than face value. Their creditors will eventually recognize losses. As previously noted, the one wrinkle is that so many producers are governments. They have not, in most cases, explicitly backed their debt with oil revenues, but they had assumed those revenues and based their future spending plans on them. Call it “soft” debt.

The dilemma is the same for both private and government producers. They can go on producing at an economic loss, for the cash flow, adding to the glut and the downward pressure on prices, or they can curtail production and their own revenues. The former is a short-term palliative only; the latter means immediate pain. Either way, total revenues accruing to uneconomic oil producers decline. Those producers will consume less—just as homeowners significantly curtailed their spending when house prices crashed, which is contractive and deflationary.

As the oil price drop leads to losses for producers, their suppliers, and creditors, assets will be sold, production curtailed, orders cancelled, and workers laid off. Eventually the price of oil will stabilize, but producers, especially government producers, may well continue to add to the glut due to short-term cash flow needs—it’s better than people taking to the streets. Even the House of Saud has committed much of its huge revenues to bribing their disaffected off the streets and keeping itself on the most kleptocratic and lucrative throne on the planet.

Dudley and Fischer refuse to acknowledge the debt daisy chain for which they and their fellow central bankers around the world are largely responsible, just as Greenspan and Bernanke have never fessed up to their mortgage-debt-and-securitization daisy chains. When oil-based debt implodes, it will stay as “contained” as the subprime implosion; daisy chains are daisy chains. However, given the much higher level of world debt now, the fallout from this conflagration compared to last time will be akin to the difference in fallout between hydrogen and atomic bombs.


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11 responses to “Oil Economics, Part 2, by Robert Gore

  1. Pingback: Make Your Own Judgment | Western Rifle Shooters Association

  2. Well Robert! I don’t like it. I don’t agree with it. You are not politically correct. You have hurt my feelings. You are a racist. I am a victim. I am being facetious. True mathematics does not care about any of the above complaints. Your take is spot on. Mathematics has no emotion. It will determine the outcome of this festering dung heap.


  3. “The Saudis are the world’s low cost producer. It is much cheaper to pump oil out of the desert than it is to frack it, extract it from tar sands or shale, or pump it from under the ocean, which is how oil is produced in much of the rest of the world.”

    Yet that is only 67% of the base cost for a gallon of gas. At least according to the eia — http://www.eia.gov/tools/faqs/faq.cfm?id=22&t=10
    That other 33% of the cost, distribution, refining, taxes is why certain sources are preferred over others.

    The more significant question might very well be who has oil at any price? Internal concerns in Kuwait, Saudi Arabia and Mexico indicate that many fields are declining in production rates. So given the situation over the long term, even though the marginal rates differ between say tar sands vs Arabian sweet crude; if tar sands is the only play then you are left with the kingdom of the one eyed man in the land of the blind.

    Additionally geopolitics plays both ways. If I had two producers of a product. One in Venezuela and one in Mexico which would I prefer? Myself the Mexican one. The Venezuelan regime has shown itself to be nothing if not confiscatory in mindset. So even at 50% cheaper price I would still go with the Mexican supplier as I know the stream of product will be more secure.

    Interesting article in the main. Especially the Bernacke comparison. That was choice.


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  6. I think that the fundamental difference between the housing market crash and the oil crash is that when the housing market crashed, people found themselves prisoners of upside down mortgages and thus were reluctant to spend. Having more money to spend due to falling oil prices would free people up to spend and give them more confidence in the markets (whether it merited it or not). This could stimulate the economy enough to create demand and new jobs, offsetting the loss of jobs from the oil sector. It could buy the economy a lot more time before it implodes from excess debt. Please post counter arguments.


    • I’m not saying that there won’t be some sort of spending from consumer who are spending less on gas, but the estimates I’ve seen put that number at under $400 for an entire year. The thrust of my argument is that in a global economy that’s about 40 percent more leveraged than it was in 2007, any major credit disturbance will set off the dominoes, which leads to asset sales, declining prices, and economic contraction. What’s going on in the oil patch I believe will qualify as a major credit disturbance.


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