Last Line of Defense

by Steve Ludlum, Economic Undertow

Figure 1: Continuous WTI futures (TFC Charts, click on for big). Price convergence results in a breakdown as customers are unwilling- or unable to bid prices higher. Absent the high prices there is insufficient cash flow to enable drillers to continue operations. Today’s marginal barrels are extracted from high cost deepwater offshore plays, from tight-oil shale formations and from ‘tar’ sands: without customer credit, drillers are more dependent upon junk bond leverage than ever.

Of course, once on the borrowing treadmill, it is impossible to step off. Borrowers must run faster to stay in place, ever-increasing amounts are needed to keep pace with operating- and service costs as well as to rollover maturing legacy debt. Consumer access to credit must be considered a ‘hard limit’ to petroleum extraction along with geology. Even as drillers are able to borrow they find there are fewer ‘end users’ with available credit … onto whom the drillers can lay off their ballooning exposure.

Conventional analysis insists that fuel constraints result in higher prices due to simply supply and demand. The assumption is that consumers will always find more funds. Instead, fuel constraints reduce customer purchasing power: customers stumble first, the drillers fail afterwards. As customers’ borrowing capacity shrinks the petroleum industry has little choice but to adjust prices to meet the market which forces drillers to reduce output. At some point they fail outright. Fuel supply cuts => diminished consumer borrowing capacity => more fuel supply cuts in a vicious, self-reinforcing cycle.

Saudi Arabia Signals It Will Let Oil Slide Further, FACTS Says

Anthony DiPaola, Robert Tuttle

Saudi Arabia, the world’s biggest oil exporter, is telling the market it won’t cut output to lift crude back to $100 a barrel and that prices must fall further before it does so, according to consultant FACTS Global Energy.

Swelling supplies from non-OPEC producers drove Brent crude into a bear market on Oct. 8 amid waning demand from China, the world’s second-largest importer. The Organization of Petroleum Exporting Countries meets Nov. 27 to consider changing its production target in the face of the highest U.S. crude output in almost 30 years.

“Production of shale oil in the U.S. will not be hit as hard as the Saudis think” by the price decline, FGE Chairman Fereidun Fesharaki said at a conference today in Doha, Qatar. Producers in the U.S. “can withstand a lot of pressure” by reining in their operating costs before they curb investment in new wells and production, he said.

Crude could drop to between $60 and $80 a barrel and stay within that range there for about six months until global production aligns with demand, Fesharaki said at the Condensate & Naphtha Forum. Oil in that range is the “right price” to balance the market, Fesharaki said.

Nobody knows what the ‘right price’ is, Saudia cannot push the oil price by reducing output: fuel constraints reduce customer purchasing power: the customers stumble first, the drillers fail afterwards. The oil industry is waking in a new world, where fuel waste is discretionary rather than inelastic; where shortages constrain- or eliminate customer purchasing power altogether rather than diverting an increased share toward the petroleum industry.

Petroleum prices have been high relative to historical norms for decades, with the breakout appearing in dollars in 1974, after the Yom Kippur War and the OPEC oil embargo:

Figure 2: nominal- and adjusted historical crude oil prices by way of BP Statistical Review, (Charts Bin – click on for big). The world’s consumption enterprise has been designed and built assuming sub-$20/barrel petroleum into perpetuity … with energy-guzzling consumer products intermediating every human activity. While the (borrowed) profits from this venture have been collected already, the costs continue to mount. One of the largest is aggregating credit expense. The question now is whether enough (resource) capital can be mustered to re-order our living arrangements or whether the status quo will simply fall apart under its own weight?

After 1974, the establishment chose to hedge against capital-resource shortages rather than meet the problem directly. Strategies included increased financialization and globalization; the shipping of Western industrial jobs offshore to cheap-labor countries, using finance credit to inflate asset prices worldwide as well as by instituting the European currency union: all of these are energy price hedges, all of them have failed completely.

Shipping Western industrial jobs overseas saved manufacturers money but not fuel, which was shipped overseas along with the jobs. Workers in newly industrialized countries used their purchasing power to buy cars and other gas-guzzling gadgets at the same time the Western workers’ purchasing power was chopped. Fuel consumption overseas (supported with direct fuel subsidies) pushed prices higher, this ultimately eroded purchasing power everywhere. Instead of conservation as an outcome of policy there is ‘conservation by other means™’.

Bubbles offer the ‘wealth effect’ that occurs when credit streams into assets … prices rise faster than the price of fuel. At some point credit becomes expensive, there are no more buyers to be had and prices collapse all at once. Those left behind are stripped of their ‘wealth’. Asset price bubbles are Ponzi schemes, the beneficiaries are the bubble promoters and well-positioned shills/insiders who are able to exit asset markets before other speculators.

Globalization allows the free flow of labor and funds, the fuel markets are globalized along with the rest. While more resources-capital is made available to industry so are more risks. Anyone, anywhere is likely be the marginal fuel consumer; that is, the user that sets the price for the everyone else ‘on the margin’. With billions of customers, it is far more likely ‘Marginal Man’ is an inhabitant of a newly impoverished country such as Russia, Brazil, China or Japan; the odds against price support for oil drillers lengthen as more countries become vulnerable due to adverse changes in exchange rates or flight of investment funds out of these countries.

The Europeans created the euro as a hard-currency alternative to the US dollar and UK sterling; to give the little countries of Europe the same purchasing power as the larger nations (and to create a captive market for larger nations’ manufacturers). Ironically, the same administrative structures put in place to support the euro have turned out to make practical fiscal union impossible. Mercantile powerhouse Germany is pitted against the rest: the outcome is failure as the vulnerable countries Greece, Spain and Italy — also Ukraine and Russia — drag everyone down.

Desperation is almost palpable as the Bank of Japan announces an expansion of its bond-buying program in an attempt to keep market forces (reality) from overwhelming the economy in that country and elsewhere. Bank of Japan boss Kuroda is a fireman for the US Federal Reserve Chairperson Janet Yellen. The central bankers are now the last line of defense for a waste-based enterprise that has exhausted both its resource- and intellectual capital. Our economic problem is not a shortage of cheap credit but a shortage of cheap petroleum. At the same time, getting our hands on the petroleum would not solve anything: our conceptual problem is dependence upon a system that only functions when capital is annihilated. Cheap credit lets us pretend a little while that ‘business as usual’ has a future; the bankers’ success undermines that future.

Petroleum is a resource, it is capital; credit and money are simply purchasing power claims against capital. In Japan and elsewhere, purchasing power is wrenched away from citizens toward the stock and bond gamblers as well as toward overseas energy producers: as the gamblers ‘win’ the citizens lose and energy producers falter. As the Bank of Japan lends, the yen is depreciated on world currency markets; as it falls the fuel price in yen increases, it becomes less affordable. Japanese customers are less able to meet higher prices for fuel => marginal demand is reduced => this causes fuel prices everywhere to tumble. The bankers are working against themselves; the more easing, the less Japanese support there is for fuel prices; the more Kuroda, the greater likelihood that the critical marginal petroleum consumer is a bankrupted Japanese.

What goes up must come down.

Monetary easing reduces borrowing costs but only for those who actually borrow. After years of easing, the only remaining borrowers are finance market gamblers. Cheap (finance) credit is used to push share- and bond prices higher in one-way markets:

L < Rs

With apologies to Thomas Piketty: leverage costs less than what the market offers to speculators. Returns Rs are determined by (artificially constrained) supply relative to demand; leverage costs L are manipulated to near-zero by the central banks: all other costs are considered to be externalities.

Credit is not the product of the central banks but of finance. The aim of central bank intervention is to manipulate the interest rate, to force real borrowing costs (interest-less the rate of inflation) as low as possible. Low interest cost renders reduces risks associated with carry trades and stock speculation; low cost + high returns = one-way markets. Theoretically, with sufficient credit, these markets can run forever. In reality, as speculators borrow, the total aggregate debt load increases exponentially while force-fed markets are subject to same diminishing returns as every other speculative endeavor. Over time there is less return for each borrowed dollar, at some point even the most outrageous finance borrowing cannot not move the markets. When borrowing capacity is required to service debts => Minsky Moment.

Manias, panics and crashes are expressions of the ‘Paradox of Thrift’, which states that one-way markets — all buyers or all sellers (or all savers) — cannot exist without severe consequences. A market where all participants are buyers means a market that is ultimately deprived of them. Everyone who is willing to buy has done so: no one remains able to ‘buy from the buyers’. A market where all are thrifty is one where money is ‘saved’ out of circulation so that day-to-day business becomes impossible. A market crash occurs when free-spenders are forced by conditions … to be thrifty all at once!

The need for a new way of economic thinking is more urgent than ever.

Quoted at length from Steve Waldman, (Interfluidity):

“Quantitative Easing” — economics jargon for central banks issuing a fixed quantity of base money to buy some stuff — has been much in the news this week. On Wednesday, US Federal Reserve completed a gradual “taper” of its program to exchange new base money for US government and agency debt. Two days later, the Bank of Japan unexpectedly expanded its QE program, to the dramatic approval of equity markets. I have long been of two minds regarding QE. On the one hand, I think most of the developed world has fallen into a “hard money” trap, in which we are prioritizing protection of existing nominal assets over measures that would boost real economic activity … “

Real economic activity so far has been little other than strip-mining capital and burning it for fun. Asset protection is a bit misleading since worth of assets = their (useless) purchasing power claims against capital: as capital is exhausted so is purchasing power. At the end of the day there are mountains of diluted or redundant claims with nothing to purchase with them. This is the fatal flaw within all redistributionist regimes which either multiply the numbers of claims or shuffle them around.

“My preferred policy instrument is “helicopter drops”, defined as cash transfers from the fisc (government) or central bank to the general public, see e.g. David Beckworth, or me, or many many others. But, as a near-term political matter, helicopter drops have not been on the table.

There are no helicopter drops because the general public has little or nothing to offer as collateral. Central banks are unable to offer unsecured loans. Should they do so they become indistinguishable from insolvent private sector lenders and are insolvent themselves => there is no effective lender of last resort => no guarantor for bank deposits (unsecured loans to banks from the general public). The effective collateral for unsecured loans to depositors would be their own deposits: the outcome => bank runs.

Support for easier money has meant support for QE, as that has been the only choice. So, with an uncomfortable shrug, I guess I’m supportive of QE. I don’t think the Fed ought to have quit now, when wage growth is anemic and inflation subdued and NGDP has not recovered the trend it was violently shaken from six years ago. But my support for QE is very much like the support I typically give US politicians. I pull the lever for the really-pretty-awful to stave off something-much-worse, and hate both myself and the political system for doing so.

‘Something-much-worse’ would be the consequences of capital exhaustion, ‘Something-much-better’ is folly: to somehow gain access to what remains of our capital so that it too might also be annihilated … in a futile attempt to pursue ‘prosperity’ for a vanishingly small period of time.

Figure 3: Declining economic activity precedes fuel price decline, (chart by ZeroHedge): unsurprisingly, expensive crude oil adversely affects economic activity.

“Much better potential economies may be characterized by higher interest rates and lower prices of housing and financial assets. But transitions from the current equilibrium to a better one would be politically difficult. Falling asset prices are not often welcomed by policymakers, and absent additional means of demand stimulus, would likely provoke a real-economy recession that would harm the poor and precariously employed. Austrian-ish claims that we must let a recession “run its course” will be countered, and should be countered, on grounds that a speculative theory of economic rebalancing cannot justify certain misery of indefinite duration for the most vulnerable among us. We will go right back to QE, secular stagnation, and all of that, to the relief of both homeowners, financial asset-holders, and the most precariously employed, while the real economy continues to under-perform.”

Waldman sees outcomes but not clearly enough. Consumption economies cannot be ‘fixed’ or adjusted but replaced with something less destructive … the Austrian economic rebalancing hypothesis is indeed faulty yet misery of indefinite duration for the most vulnerable among us is both certain and underway. It is a consequence not an alternative. We multiply ourselves and our appetites without restraint and devour our increasingly scarce capital without any thought other than to do so before someone else beats us to it. A better economy would reward those who husband our capital, to tend what remains rather than seeking to gain the pawnbroker’s pittance

…

The drillers are canaries in the coal mine, even as they are able to borrow they find there are fewer ‘end users’ with available credit … onto whom they can lay off their ballooning exposure. In place of the non-existent customers is the central bank, a conduit by which credit costs are shifted from the bankrupt customers to the same customers’ children. This is the last line of defense … what remains between our fantasies of endless creature comforts and the pit.