Last December, in “Oil Ushers in the Depression,” SLL said that oil was on the leading edge of global economic and financial contraction.
The future is now. The carnage in the oil sector, where a glut has knocked over a third off its price in less than five months, is not an aberration, but a harbinger—the shape of things to come across sectors and around the world. It kicks off the depression, or more accurately, the resumption of the depression that started in either 2000 or 2007 (let the statisticians quibble about that determination).
That forecast may have seemed extreme at the time. The global economy was still growing, albeit slowly. Mainstream economists were predicting that 2015 would be the year it reached liftoff velocity, thanks to central banks’ quantitative easing and interest rate suppression. Those predictions betrayed appalling ignorance of the central force in the global economy—debt—and its dynamics during expansions and contractions, what SLL has termed “debtonomics.” (See the Debtonomics Archive for more.)
Now, after a rout in commodities, dwindling or negative growth worldwide, and widespread financial turmoil, including a rough third quarter for most equity markets and steadily widening credit spreads, the forecast looks less extreme. Even mainstream economists, in their ever cautious, toe-in-the-water way, are acknowledging that there might, just might, be a possibility (usually expressed in terms of a percentage in the neighborhood of 10 to 25 percent) that the economy heads into a recession. When the depression resumes, they’ll go back and cite that kind of well-hedged piffle as proof positive that they knew it all along.
Cutting through the weaselly verbiage, the global economy is at a precipice the likes of which it has never been at before, and it’s look-out-below time. Oil continues to offer the perfect economic, financial, and geopolitical analytical template, at the nexus of debt, blood, and governments’ incompetence and corruption.
One of the more vacuous concepts out there is what’s called “the resource curse.” The idea is that countries with abundant natural resources coast on those resources and economic development in other areas is stunted. One can certainly find examples; Venezuela may be the poster child. However, the world’s most advanced and technologically developed economy resides in a country that has been “cursed” with abundant natural resources—the United States—an example not usually cited in the “resource curse” literature.
Venezuela is the poster child for the real curse: statism. Once upon a time, the US had its opposite: “the freedom blessing.” The contretemps in the oil patch are a clash of statist titans: Saudi Arabia, Russia, and the Federal Reserve. The Fed and other central banks have monetized financial assets, mostly government debt, and suppressed interest rates. Cheap debt funded America’s oil patch fracking “revolution” as yield-starved investors ignored negative cash flows at many companies, and the risks that the price of oil could go down as the new US production added to supply.
Both Saudi Arabia and Russia find themselves on the wrong end of the debt and commodity bust. Saudi Arabia’s economy is almost entirely dependent on oil. Russia’s is more diversified, but unfortunately for it that diversification is mostly other commodities subject to the same debt dynamics as oil. Massive government and central bank debt formation globally have produced decades-long distortions that have left the world awash in mines, raw materials, factories, transportation facilities, structures, stores, and everything else that can be funded by debt. Neither Saudi Arabia nor Russia have ever known the freedom blessing, the font of economic progress that would have led to healthy diversification. Now they have little choice but to keep pumping oil; it’s their major source of revenue.
Doing so, they illustrate an important aspect of debt deflation: just as governments and central banks artificially inflated the bubble on the way up, they are going to make the bust far more prolonged and painful on the way down. In the US, frackers have run into low oil prices and the limits of low-cost money and have responded accordingly. They are keeping their most efficient rigs running, idling the rest, and reducing production and expenses. Debt has been restructured and companies have gone bankrupt. Prices of oil production assets have dropped to what, a year ago, would have been regarded as fire sale levels. This is how capitalism cleans up its errors. Governments make bad situations worse.
Fiat debt at below market rates creates superfluity. What the world economy desperately needs is more of what’s going on in the US oil patch: creative destruction and Darwinian winnowing. Unfortunately, policy makers and central banks, having blown their gargantuan debt bubble, are going to try to keep it inflated, and, once it busts, they’ll prolong the bust in counterproductive attempts to staunch the pain. These efforts will only delay or prevent necessary adjustments. China’s and Europe’s central banks served notice last week: more cheap fiat debt. Saudi Arabia and Russia, hemmed in by the realities of state-directed, resource-based economies and welfare-state spending, and further encumbered by Middle Eastern military commitments, are pumping oil at glut-perpetuating full tilt.
Iraq, Venezuela, Brazil, Mexico, Iran, and Kuwait are all significant oil producers in which the state’s hand weighs heavily on the industry. Along with Saudi Arabia and Russia, they may well continue to produce beyond the point of economic rationality, perhaps covering cash costs but not recovering capital expenditures for exploration and development. Or, if the local oil company or companies are state-owned or heavily state-influenced and are large employers, and especially if the work force is unionized and a major bloc of votes, production may continue although it does not cover cash costs, as politically expedient make-work. There will be occasional bounces, like this summer’s, but such noneconomic considerations will keep the price of oil low for a much longer time than most experts currently foresee (see “The Shape of Things to Come,” SLL, 8/28/15).
The old saw in commodities markets is that the best cure for low prices is low prices, but that assumes economic rationality among market participants. As debt deflation deepens, prices stay low, and markets stay glutted, expect governments dependent on their countries’ natural resources for jobs and revenues to disregard those economic factors. In so doing, they will increase their economic distress and forestall adjustment, prolonging the agony. Boxed in, governments may seek to divert attention from their economic mismanagement and rally their populaces by making war, which will only increase their fiscal stress. So look for continued pain in natural resources, and perhaps an upside breakout for warfare, which would be one of the few upside breakouts. It wouldn’t be unprecedented. World War II followed the Great Depression.
RADICALLY DIFFERENT, RADICALLY READABLE
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The pain of course will not just be limited to commodities. Oil followed its historical pattern of wildcat the supply side till I can’t make the payments on Boopsies plastic surgery. But commercial real estate was leading the parade on debt deflation by at least 5 years before the Shale Bust and is still continuing. Essentially anyone who played an investment too close to the edge on marginal returns vs debt structure is circling the drain. Comm RE especially since most long term notes have reassessment clauses at 5 year intervals.
No, the pain will certainly not be limited to commodities. It will be harder to find things that don’t feel the pain than that do.
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