This is not an analysis of the natural gas market, but rather an explanation of why it’s price graph will be the shape of things to come, not just for natural resources, but for manufacturing and equities. At first, natural gas’s price rose even as a flood of capital was expanding production, precursor to what occurred in oil and other natural resources several years later. In a free market, speculative capital would have been attracted to the possibilities opened up by natural gas fracking. In a world in which central banks have for decades supplied more debt at cheaper interest rates than what would have prevailed in a free market, that flow of capital was amplified. Consequently, so too was the number of natural gas rigs put in operation, the amount of natural gas produced, and the subsequent crash in price. The same can be said for the progressions that came later in oil, iron ore, aluminum, coal, copper, and other extractive industries.
Abnormally cheap, abundant debt does not just distort supply, it distorts demand. The number one distortion is China. It has been on a multi-decade debt binge that has fueled capital spending, manufacturing, production, and an infrastructure build-out. China sucked in raw materials from all over the world, notably Latin America and Australia.
In the US and Europe, government and private debt primarily funded consumption, financial debt went into speculation, and corporations borrowed money to fund share buy backs and dividends. China and oil exporting nations engaged in vendor financing, recycling their trade surpluses into the debt of nations buying their exports. It was a virtuous circle of sorts: production of all manner of natural resources and manufactured goods, amped up by cheap debt, found end markets in countries where consumption had been amped up by cheap debt.
Total world debt increased far faster than the underlying growth rate of the global economy, which meant that assets and income streams became increasingly encumbered by debt claims. It also meant that despite low interest rates, the burden of debt service increased, exerting an ever-heavier drag on the real economy. A broad-based transition from debt expansion to debt contraction first manifested itself in commodities in 2014. The graphs for many natural resources took on the grim aspect of the above natural gas chart after 2008; their prices crashed.
Just as with natural gas, crashing prices impaired and in some cases impaled the ability of indebted producers to service their debts. Credit spreads in the natural resource sector have blown out. Several coal producers and oil fracking companies have gone bankrupt and more will follow. Contraction and financial stress are moving up the production chain. There are already gluts in steel and autos, and the bulk of growth registered in US GDP in the first and second quarters has been due to inventories building. Production cutbacks and layoffs are coming, followed by reductions in consumption by the newly unemployed and further cutbacks and layoffs.
Take another look at the natural gas chart. It’s been over seven years since the price topped out, and it is still only about 20 percent of what it was then. In the bad old days of something closer to dog-eat-dog free market capitalism, downturns were vicious, but they were comparatively short. Gluts in raw materials and crops, intermediate and finished goods, and employment were fixed by falling prices and wages, liquidation and bankruptcy, and newly cheap assets moving from the weak and indebted to the strong and solvent. The depression of 1920-1921 is the most recent example. It was brutal, but it was also over in less than two years (see The Forgotten Depression: 1921: The Crash That Cured Itself, James Grant, Simon and Schuster, 2014) as the government and the Federal Reserve sat on their hands. (The Fed actually raised rates!)
In today’s no-pain-allowed environment, it took seven years before two natural gas producers even went bankrupt. The chart illustrates the harm from the Fed’s ultra-low interest rates, now in their 80th month. They have been perpetual life support for terminally-ill companies for whom the machines should have been turned off long ago.
If you’re looking for when natural gas and other commodities might “recover” and regain their former highs, consider the Japanese stock market. Way back on December 29,1989, the Nikkei 225 made its all-time intra-day high at 38,957.44 and dropped for almost 20 years, 81.9 percent to 7054.98 on March 10, 2009. After rallying strongly the last two years, the Nikkei closed Friday at 19,136.32, which means that it still has to rally over 100 percent to regain its 26-year-old high. Nobody has gone in for government indebtedness, central bank monetization of assets (the Bank of Japan now buys equity ETFs as well as most of the government’s debt), and keeping zombie companies alive as long and with as much fervor as the Japanese, but nobody would argue that these nostrums have done anything but prolong the pain.
With governments’ and central banks’ “help,” the prices of natural gas, other natural resources, goods, and labor may remain depressed for years to come. As the greatest debt bubble in history unwinds, attempts will continue to forestall or prevent markets from making their painful, but necessary adjustments, However, gravity can only be fought for so long. With contraction and falling prices becoming the order of the day in the real economy, it takes a triumph of hope over experience to think financial assets will be immune. Bid farewell to the S&P’s all-time intraday high of 2134.72 on May 20, 2015. It may be a long, long time before the index sees that level again.
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You know, that chart really shows something quite different. Gobs of money to fund an opportunity to achieve lower prices was quite successful. Ask any consumer if they think the price they are paying today vs the day Obama took office and they will smile.
What is wrong is that the incentive of using debt was a bad choice. Had intrinsic capital formation in the industry been used a higher floor price would have been achieved and there would have been a lower well count with reserves for more. Producers in many industries are going to reap a whirlwind of hurt for the overcapacity in the supply chain.
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Debt was not necessarily a bad choice, but the debt was mispriced (the interest rate was too low) because of central bank suppression of interest rates. As you note, had intrinsic (market-based) pricing for capital, both debt and equity, been used, “a higher floor price would have been achieved,” one in which producers did not end up producing at a loss. The chart shows the effect of that debt mispricing: a glut of natural gas, prices at unprofitable levels, and the lengthy duration of such pricing as mispriced debt continued to flow to the industry, keeping zombies that would have long ago gone bankrupt in a market-based regime alive and producing, in turn prolonging the glut and low prices.
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Mr. Gore: Since you are describing a deflation scenario, what would happen, then, if exploration and mining of this needed commodity were to stop? Wouldn’t the price go up? My elders told me that during the Great Depression, farmers would deliberately plow under their crops or dump them in the river to keep the prices up. And, like the home heating oil political football back east, the FEDGOV would step in and make all kinds of regulations and threats. Am I mistaken?
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In a free market, exploration and mining wouldn’t stop, it would be curtailed to those efforts that promised the highest return. Some capital would be withdrawn from the industry, and what remained, either equity or debt, would demand a higher return. The glut would be worked off, and as you state, the price would go up. When interest rates are suppressed by a central bank, the price of capital stays low, encouraging continuing production and delaying the price adjustment, which is what we’ve seen with natural gas.
You are not at all mistaken about the Great Depression. The government did all sorts of things that turned a bad recession into the Great Depression. One of the worst was price maintenance, especially for agricultural goods (a significant portion of the population, and electorate, were farmers back then). The government decreed an above market price for a crop, and surprise, surprise, there was a glut, which in many cases led to the deliberate destruction of crops that you site. For some great information on government ineptitude during the Great Depression (no, the New Deal did not “save” the economy, it almost destroyed it), see The Forgotten Man by Amity Shlaes, America’s Great Depression by Murray Rothbard, Rethinking the Great Depression by Gene Smiley, FDR’s Folly by Jim Powell, and The Roosevelt Myth by John T. Flynn. As I said on another post, the one thing you can count in a deflationary debt contraction is that governments will make it worse, and Roosevelt and his gang of statists certainly did during the Great Depression.
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Good stuff, Robert.
I’m a longtime reader at WRSA, close with CA.
Fracking allowed us to get at a whole lot of natural gas. The price of natural gas made it economically feasible. One thing I don’t see mentioned here is the political aspect of low gas prices.
The War On Coal (TM) has been going on since about 1999 when the big New Source Review lawsuit kicked off. Up until about 2008 (also known as the Age Of Obama), the greenies pushed for more regulation through the government. Utilities-particularly regulated utilities went along with this because they could help “shape” the regulation and have certainty about their futures. Put another way, they knew that they would have to add on billions of dollars of environmental controls, but they could take these to their state public service commissions and present them as necessary capital additions that MUST be done in order to keep coal fired generation online. (Remember, coal was still cheaper than gas.) The PSC’s generally went along, and utlilites made money-even in the face of increased environmental regulation. Why? Because they are generally guaranteed a certain rate of return on the capital dollars that their state’s PSC approves them to spend.
However, since 2008, we’re getting into destructive regulation. The EPA now has clearly signalled that their intent is to kill coal. What a coincidence, there’s suddenly a cratering of natural gas prices and an abundance of a much cleaner energy source. What has happened since then in the world of electricity is that gas is displacing coal on “the stack”. The stack is simply the ordering of all the generating assets from cheapest to most expensive. Typically, the hydro units go first because water behind the dam is free as an energy source and dams have very low O&M cost. (How many people does it take to operate penstocks at the dam anyway?) So there are a ton of combustion turbines and combined cycle units out there that displaced coal units so that many of them are sitting on reserve shutdown almost all the time. I haven’t looked, but I shudder to think what the capacity factor is for coal units compared to natural gas prices over the same period as your chart.
Additionally, the economy has tanked so demand on the grid has gone down. Coal loses again. Worse, older coal units that are marginally viable are being shut down like crazy. You simply can’t justify spending a couple hundred million dollars to keep them online when they won’t be on economic dispatch. So what about all those flagship units where the billions have been previously spent on environmental controls? The utilities have a huge problem coming. if the EPA wins here and those units get closed down, then you have literally billions of dollars of stranded assets whose cost has not yet been recovered. (through you and I the rate payers/customers).
But it’s even worse still because “clean” power sources like wind and solar can literally dispatch at $0/kWH and displace someone else down the stack. How? Because they’re flush with government subsidies. Hope. Change.
With the diminished need for coal, coal producers are now starting to go bankrupt which threatens the remaining plants that do use coal. It’s a cute little downward spiral. I submit to you that The War On Coal (TM) is proceeding exactly as this administration wants it to proceed.
In the near future, the old marginal units will largely be gone such that the only coal burners left will be the flagships. Utilities who have previously gone along with all of the environmental control requirements are realizing that it’s not about the environment. It’s about control. The ultimate aim here is the destruction of coal as a source of energy in this country. Once that is accomplished, look for the worm to turn once more towards placing a noose around natural gas. Examples: Denial of natural gas pipelines, regulation of fracking operations, etc. Oh wait, these are already starting to happen.
It’s not going to be real good for the folks in District 12. But as usual, those in Capital City will continue to flourish and accumulate power and prosperity. It’s The Hunger Games all the way down.
You’re right on track, RG. I just wanted to add another dimension that you may not have thought of.
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Wow! Thanks for the amplification and new information. This is great for me and SLL readers. Keep those comments coming.
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OK, I am going to play devil’s advocate. Nothing personal ya understand.
Is coal a dead duck? Well Ichan back in May bought into CHK and they are a major producer/consumer of coal. Then Soros just this month bought 1.9m shares of CHK. CHK is also into oil and gas holdings so they have a diversified portfolio. When Soros bought CHK was trading at been $6-7/share. CHK was as high as $90/share just a few years ago.
I generally don’t go with conspiracy theories, they are had to maintain if they do exist and rarely achieve their aims. But here goes. Soros is chums with a bunch of players that float around the white house. Soros suggests a green play, that coal should not be used. Knowing that stock prices in coal holdings will drop dramatically. The political machine goes to work, the stocks drop. The vultures arrive and stake their positions on the carcass. So if this goes to plan the next move would be that the EPA either reverses course or loses a legal position on say C02 vis a vis the coal industry. In a strengthened position holders of coal properties stock rises. Vultures cash out.
Now you are talking a political play at a national level of untold proportions. But is that not Soros’s track record over the years?
Take it for what it is worth. I am just posing the observation.
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