The consensus view on the recent plunge in oil prices is that it is a net positive. The logic involved is that the falling price represents a transfer of wealth from oil producers to oil consumers, and as there are far more of the latter, the boost to consumer spending will outweigh any difficulty faced by oil producers.
This logic would be sound if it was simply a case of increasing production satisfying consistent demand. The following chart suggests that is not the case:
While supply has risen over the last 5 plus years, the extent to which it has risen has been exaggerated a bit in relation to the explanations for the oil plunge. The supply rise has been relatively consistent, and even with the recent boom in US shale oil, the additions to the global supply from that boom have not been so dramatic as to send the global supply kiting through the roof. The main issue has been the lack of demand for oil at the levels that prevailed for most of the last 5 years, between $70-110/barrel. In the face of the recent flattening of demand (which OPEC expects to further decline in 2015), combined with the unchanged supply situation, a price drop is to be expected.
The next issue to resolve is the reason for the declining demand. As Irving Fisher wrote in his 1913 article The Monetary Side of the Cost of Living Problem, analysis of the supply and demand conditions relating to the good itself is only half of the picture. The monetary condition is equally as important for determining the whole story. From that standpoint, we turn to the Fed. The following is a chart displaying the year over year change in the Fed balance sheet compared with the price of oil.
The heavy pre 2010 year over year changes in the Fed balance sheet reflect the magnitude of the original Quantitative Easing program. The subsequent iterations of QE had less of an impact on the growth of balance sheet in relative terms, each time ‘only’ increasing the Fed Balance sheet roughly 40% year over year. This has been accompanied by price action in oil which has basically oscillated in a $40 range. I’ve mentioned multiple times that for QE to achieve the goal of constant price increases, each increase of the balance sheet has to be larger than the last, in relative terms. Since the original QE increased the balance sheet by 100%, subsequent increases of the balance sheet have to be in excess of 100%. Failure to do this will result in downward pressure on prices as the relative flow that is responsible for boosting prices starts to deteriorate. As I wrote in ‘Underpants Gnome Economics’:
Not only does active tightening place downward pressure on prices, but inaction by the Fed also leads to lower prices. Once prices have been pushed higher via accommodative policy, their continued rise depends on continued demand, which can only express itself when there are increased dollars in circulation. A relatively stable money supply does not suffice, and compared to an expanding supply, this stance is actually tighter, even though the absolute level of money in circulation may be very high. This is especially true in the face of an increased supply of goods and services.
Despite engaging in unprecedented easing of monetary policy in absolute terms, the fact that the Fed has been relatively tight (especially with the tapering of QE3 beginning in September 2013) means that deflationary pressures are certain to reassert themselves.
A few have been speculating in recent weeks that oil may be the first place in which this deflationary pressure appears. I joined them the other day in examining the implications of an oil collapse. Since then, the line of reasoning I presented (that the oil decline might reveal a layer of bad debt and pose a threat to the financial system) has been buttressed by a number of news articles with gloomy implications. From Bloomberg this morning:
In a stunning analysis this week, Goldman Sachs found almost $1 trillion in investments in future oil projects at risk. They looked at 400 of the world’s largest new oil and gas fields — excluding U.S. shale — and found projects representing $930 billion of future investment that are no longer profitable with Brent crude at $70.
The Goldman tally takes the long view of project finance as it plays out over the next decade or more. But the initial impact of low prices may be swift. Next year alone, oil and gas companies will make final investment decisions on 800 projects worth $500 billion, said Lars Eirik Nicolaisen, a partner at Oslo-based Rystad Energy. If the price of oil averages $70 in 2015, he wrote in an email, $150 billion will be pulled from oil and gas exploration around the world.
An oil price of $65 dollars a barrel next year would trigger the biggest drop in project finance in decades, according to a Sanford C. Bernstein analysis last week.
Unprofitability at a lower price means a reduction in outlays for future production. This means a decline in employment and utilization of capital, as this BBC article mentions:
“It’s almost impossible to make money at these oil prices”, Mr Allan, who is a director of Premier Oil in addition to chairing Brindex, told the BBC. “It’s a huge crisis.”
“This has happened before, and the industry adapts, but the adaptation is one of slashing people, slashing projects and reducing costs wherever possible, and that’s painful for our staff, painful for companies and painful for the country.
“It’s close to collapse. In terms of new investments – there will be none, everyone is retreating, people are being laid off at most companies this week and in the coming weeks. Budgets for 2015 are being cut by everyone.”
Mr Allan said many of the job cuts across the industry would not have been publicly announced. Oil workers are often employed as contractors, which are easier for employers to cut.
His remarks echo comments made by the veteran oil man and government adviser Sir Ian Wood, who last week predicted a wave of job losses in the North Sea over the next 18 months.
The US-based oil giant ConocoPhillips is cutting 230 out of 1,650 jobs in the UK.
This month it announced a 20% reduction in its worldwide capital expenditure budget, in response to falling oil prices.
Other big oil firms are expected to make similar cuts to their drilling and exploration budgets. Research from the investment bank Goldman Sachs predicted that they would need to cut capital expenditure by 30% to restore their profitability at current prices.
Service providers to the industry have also been hit. Texas-based oilfield services company Schlumberger cut back its UK-based fleet of geological survey ships in December, taking an $800m loss and cutting an unspecified number of jobs.
On Wednesday Aberdeen-based Wood Group announced a pay freeze for staff, and cut rates for its contractors.
Apache, one of the North Sea’s biggest producers, has followed suit and will impose a 10 percent reduction on its contractors’ wages from January 1st.
Capital Expenditure reduction. Employment reduction. Wage freezes/reductions. All of these have knock on effects in the shape of reductions in spending in other areas, not to mention the pressure that bad loans puts on the financial sector. The oil decline is a classic debt deflation in the making, which is a totally different prospect to the positive ‘it’s like a tax cut’ interpretation which is the consensus view at the moment.
Despite the potential bleak situation, the solution is to actually embrace the oil declines, because the falling price is the cure. The real problem was the proliferation of credit and debt issuance which roughly tripled the oil price rise from the 2009 depths to its stasis in the $70-110 range, enabling an expansion of investment, capital formation, and an increase in production costs. These unsustainable developments have now been revealed, as the inability for the economy as a whole to sustain high oil prices has led to a drop in demand, and thus the price. The drop in price now renders a lot of the credit undertaken in the past dubious in nature. Inevitable credit contraction and liquidation will follow, perhaps culminating in a reduction in oil supply. However, the end result is a situation in which stability returns. Costs of production will fall along with the price, to a point where investment projects can be undertaken profitably again, leading to the resumption of hiring and production. This is how markets work to correct imbalances.
Unfortunately, central bankers do not like the way markets work, so they will attempt to intervene. As it stands now, the Federal Reserve seems unperturbed by the move in oil prices, based on Janet Yellen’s press conference yesterday. If and when the issues I’ve mentioned rear their heads, the interpretation of any troubling situation will be that it is the low price which is the problem. The erroneous view that price moves cause changes in economic fortunes, rather than merely being effects of those changes, will lead the FOMC to resume easing, in ever greater amounts, to bail out anyone who may have been harmed by the pitfalls of a contraction of bad debt. The end result of this intervention will likely be a propping up of prices at elevated levels, the exact phenomenon which enabled an unsustainable edifice of oil development funded by leveraged financial institutions to be constructed in the first place. Let’s not get too far ahead of ourselves though, these developments are a few steps down the road, but it’s a road we’ve travelled on multiple times in the last 15 years. It’s hard not to be concerned.