Why is a falling oil price bad for many asset markets?

by on January 16, 2016 at 8:31 am in Current Affairs, Economics | Permalink

But there is, I believe, something else going on: there’s an important nonlinearity in the effects of oil fluctuations. A 10 or 20 percent decline in the price might work in the conventional way. But a 70 percent decline has really drastic effects on producers; they become more, not less, likely to be liquidity-constrained than consumers. Saudi Arabia is forced into drastic austerity policies; highly indebted fracking companies find themselves facing balance-sheet crises.

Or to put it differently: small oil price declines may be expansionary through usual channels, but really big declines set in motion a process of forced deleveraging among producers that can be a significant drag on the world economy, especially with the whole advanced world still in or near a liquidity trap.

That is from Paul Krugman, speculative (as I think he would admit) but worth a ponder.

Another possibility is simply that, along with China and ongoing terror attacks, investors are realizing they don’t understand the world nearly as well as they thought they did.  Or perhaps the rapidly falling price means one set of investors is learning from another just how soft the demand curve is, thus spreading bearish sentiment.

Addendum: Izabella Kaminska adds comment.

1 Ironman January 16, 2016 at 8:43 am

Ripped from the headlines:

BOK Financial to increase provisions for bad loans as oil slumps

Citigroup, Wells Fargo gird for loan losses as oil price dives

This dynamic goes a long way toward explaining what’s behind the deceleration of private debt in the U.S.,, which is strongly correlated with periods of falling GDP growth rates.

2 chuck martel January 16, 2016 at 9:26 am

Reuters: “The oil price rout has dominated the start of U.S. bank earnings season despite energy loans accounting for 3.4 percent or less of the major banks’ portfolios, according to analysts at Barclays bank.”

3 T. Shaw January 16, 2016 at 10:30 am

Reuters, bless their hearts, the banks’ oil depression becomes more material when one looks at balance sheets. Say 60% of bank total assets are in loans and 8% of total assets are regulatory capital and loan loss reserves, that 3.4% (small concentration) would be 26% (above 25% would be a concentration of risk) of capital and reserves; plus banks have loan losses in all other loan categories. If it’s (unlikely) all losses, loan loss reserves would need to be replenished over and above normal loan loss provisions. That’s not an immediate threat to solvency, but is a drag on earnings which drive stock prices.

4 Yancey Ward January 16, 2016 at 10:34 am

Shorter Reuters: “It is well contained.”

5 Alain January 16, 2016 at 11:36 am

This is the common explanation and it has solid legs. I don’t think we Krugman to try to dress it up as ‘non-linear’ and ‘austerity’.

The story, as far as we understand it today, is that price drops in oil and commodity prices may soon unleash a number of bankruptcies and the markets do not like this uncertainty. Film at 11.

6 yo January 16, 2016 at 11:45 am

Doesn’t the “anything that has to do with buying oil, such as transportation, plastics etc is now cheaper” effect outweigh the Saudis’ now being able to buy less jewellery?

7 Alain January 16, 2016 at 2:31 pm

I don’t think anyone cares about the Saudis not being able to buy their luxury items. I think the concern is more about capital that has been deployed to drill for oil, mine for copper and steel, etc, that may not, in the end, generate much of a return.

Planning is hard. Markets do a pretty darn good job of it, but they make mistakes.

8 RM January 16, 2016 at 4:18 pm

Except that markets seem to make mistakes too often these days. In any case, what fraction of global investment does the oil industry represent? Less than 2 percent? All of mining? Less than 5 %?

9 Boonton January 17, 2016 at 10:01 am

“Ripped from the headlines:”

“Citigroup….”

It says Citigroup set aside $200M for losses related to low oil prices impacting loans but might increase that to $600M. In terms of megabanks that’s peanuts. It doesn’t even say it will cause the banks losses, just lower their profit expectations slightly. During the mortgage crises we were talking about losses in the range of hundreds of billions.

When perusing ‘screaming headlines’ it’s important to reflect on how these stories really look if you scale them up against the big picture.

10 Gochujang January 16, 2016 at 9:00 am

investors are realizing they don’t understand the world nearly as well as they thought they did

A classical cyclical event?

11 prior_test January 16, 2016 at 9:06 am

Yep, as if investors have been completely blindsided by the boom and bust cycles that have pretty much marked the market for oil since its beginnings.

12 Kline January 16, 2016 at 9:38 am

…but oil producers & investors can rely on a savvy corps of economists (like Krugman) who saw all this coming… and know exactly how to predict/prevent/cure economic crises. Relax.

Of course the wacko fringe sees this as standard boom/bust caused by government easy money. Gross malinvestment in oil (and much other stuff) is being rectified/liquidated by market forces. The 2008 Great Recession never ended– the cancer was merely masked by staggering government malfeasance.

13 prior_test January 16, 2016 at 10:21 am

I’m sorry, but do you honestly think oil producers like Exxon or Aramco need economists to tell them anything about how oil markets work?

If so, you really don’t understand the influence of those two entities – they are the ones riding the waves they in large measure create. As for the Saudis – they could easily double the price of oil in less than 24 hours by announcing they were cutting their exports by 50%. Wonder why they don’t?

Think Russia (and before that, the Soviet Union) and Iran as geostrategic opponents, keeping customers dependent on oil for as long as possible, destroying producers that were threatening Saudi market dominance (think American fracking and Canadian oil sands in combination, and then reflect on how determinedly Saudi policy is targeting the publicly accepted illusion of American oil independence). Then add in the reality that the Saudis have a better idea han anyone else how much oil they actually have left to pump – Aramco is truly a world class oil company, run by people whose mastery of oil markets has been essentially undisputed for two generations.

They don’t waste their time on economists. The latest technology for oil discovery, recovery, and refining, however….

14 brickbats and adiabats January 16, 2016 at 9:18 pm

Both of those are doubtful. Exxon always, since they have well under 2% of global production, and Aramco since the early 2000s since it is widely believed that they ran out of spare capacity during that decade, hence the rapid price increase. Aramco is toothless as a swing producer now.

15 y81 January 16, 2016 at 9:17 am

The one thing Krugman readers know is, it’s not Obama’s fault. If it happened under a Republican president, it would be his fault (in fact, our current problems might still be Bush’s fault), but it can’t be the fault of a Democrat. That’s why I don’t read Krugman: my time is too valuable to waste on partisan hackery.

16 rayward January 16, 2016 at 9:20 am

Of course, Krugman blames inadequate aggregate demand for the economic malaise – and he sees falling asset prices as further reducing aggregate demand (deleveraging and austerity), exacerbating the problem. But what if the root of the problem isn’t aggregate demand per se, but something else that contributes to inadequate aggregate demand? Economists who disagree with Krugman, especially his prescription of increased government spending to increase aggregate demand, disagree because they don’t believe aggregate demand is the root of the problem. For them, falling asset prices is a feature not a bug (a feature if investors are rational and can see an opportunity (i.e., falling prices) when it’s presented. Unfortunately, irrational behavior tends to be infectious, especially among owners of capital, the fewer of them the more likely they follow the irrational herd.

17 Gochujang January 16, 2016 at 9:35 am

Oil price, in retrospect, seems rooted in yet another over-expansion of capacity. The industry turns on long (20 year?) cycles, with as prior says, booms and busts.

I think the connection to general markets is emotional, but as Krugman says, there are a lot of energy companies genuinely damaged.

18 prior_test January 16, 2016 at 10:38 am

‘Oil price, in retrospect, seems rooted in yet another over-expansion of capacity.’

Over priced capacity – there is a lot of oil in the world at 200 dollars a barrel, but fewer people to buy those barrels, and there is a lot less oil at 30 dollars a barrel, though the number of buyers for that oil seems pretty firm for now.

The booms and busts are a constant of how the oil industry works. Along with quasi-monopoly price control through a single entity, whether that be the Railroad Commission Of Texas or OPEC or these days, apparently the KSA by itself – ‘Established by the Texas Legislature in 1891, it is the state’s oldest regulatory agency and began as part of the Efficiency Movement of the Progressive Era. From the 1930s to the 1960s it largely set world oil prices, but was displaced by OPEC (Organization of Petroleum Exporting Countries) after 1973. In 1984, the federal government took over transportation regulation for railroads, trucking and buses, but the Railroad Commission kept its name. With an annual budget of $79 million, it now focuses entirely on oil, gas, mining, propane, and pipelines, setting allocations for production each month.’ https://en.wikipedia.org/wiki/Railroad_Commission_of_Texas

19 Thomas January 16, 2016 at 2:19 pm

Inadequate aggregate demand is nonsense to think about because if there is inadequate aggregate demand to support the expenses of oil producers, it is tautological that oil producers have expanded too much. Easy money is a terribly unsophisticated way to grow an economy, when compared to market solutions. How do we stop this problem from happening in the future if we, as I presume Krugman would have it, inject money into the oil industry to prevent those bankruptcies from happening?

20 ChrisA January 16, 2016 at 9:32 am

The fall in the price of oil impact on many producing countries in the Middle East has been exacerbated by the very rapidly rising US Dollar since their currencies are often pegged to the dollar, dollar trade weighted level has gone from 75 to 95 in last 6 months driven by the US tightening monetary conditions (Fed interest rate increase and tightening rhetoric). So now not only have revenues fallen with the price of oil, but they are also experiencing deflation in other goods. Its a similar problem for the Chinese, whose currency is also effectively dollar pegged. The US is exporting deflation to the rest of the world. Of course, if these countries didn’t have the dollar peg, their currencies would devalue, like the Russian Ruble has, which would then offset the problem. So again the liquidity trap is really just another word for stupid economic policy by CBs.

21 Gochujang January 16, 2016 at 9:36 am

The world has been facing falling inflation for decades, it is just low enough now to be scary. Not exported. Shared.

22 Gochujang January 16, 2016 at 10:49 am

There are two drivers on a hook-and-ladder truck. Most people seem to think central banks are figuratively at the front wheel, deciding where to go. I think they are at the back wheel, trying to hold things together. The global economy produces emergent inflation rates and real interest rates based on global savings and global demand for debt. The CBs cannot stray far, they must stay in line or they catch a figurative curb.

A “stupid economic policy by CBs” can certainly destroy a currency or trigger government default, but “good” policy is constrained. This is what produces the parallel efforts by big government CBs to hold things together.

23 ChrisA January 16, 2016 at 11:10 am

Gochujang – even of there is deflation due to an excess supply of savings (which I doubt) it doesn’t mean that the CB can’t create inflation to offset it. The Russian economy for instance seems able to generate inflation despite these factors. CB can always create additional money, and if that additional money doesn’t cause enough inflation, then they can always create more and more.

24 Gochujang January 16, 2016 at 11:14 am

“Consumer Prices in Russia rose 12.90 percent on year in December of 2015 after increasing 15 percent in November.”

That might be the bad driving to which I refer. I think it is much harder to “hold things together” and generate “desired” interest rates. The market fights you, right? You get currency flows, carry trades, changing valuations …

25 Thomas January 16, 2016 at 2:22 pm

Guaranteeing against poor performers becoming bankrupt performers while simultaneously increasing regulatory burden for all performers, as we saw in the attempt to save banks, is like putting in price ceilings and mandating certain amount of production. The Fed isn’t the whole story. Taking everything together it is Hayek’s fatal conceit with Krugman and every arrogant leftist wanting to be in the driver’s seat.

26 Nancy January 16, 2016 at 9:32 am

Too many people who claim to be paying attention haven’t been or they wouldn’t be getting so bent out of shape over the fact that the world is a dangerous place. Events have consequences, so here we are with a proverbial pileup. What will happen? Hopefully we will muddle through it all as all the shocks play out over time.

27 Bill January 16, 2016 at 9:37 am

There are externalities from high oil prices caused by an Arab oil cartel. Bush has to travel to Saudi Arabia to ask them to lift more oil, please. We have oil spills to extract oil from sensitive environments–ANWAR, etc. Canadian tar sands become profitable.

Let’s see where the price of oil settles without an effective cartel.

Let’s also ad to the ledger externalities instead of just price.

28 prior_test January 16, 2016 at 11:12 am

‘Let’s see where the price of oil settles without an effective cartel.’

Currently, the Saudis have taken over from a cartel, though how long they can remain dominant is not only open to question, but likely limited to years, as compared to decades – see above.

And the Iranians know it – OPEC is becoming increasingly irrelevant, and the only thing the Iranians can do is pump more oil into the market, which just plays into what seems to be the Saudis’ current strategy to become the dominant setter of the price of oil – much like the Texans, though it is unlikely the Saudis will have a decades long run.

And never forget that a lower price of oil is certainly intended to slow the transition of transport technology from fossil fuel based internal combustion to another energy source.

On the other hand, no one seems to have Churchill’s vision when it comes to changing the energy source of an entire institution to respond to a changing world (the world’s deserts, especially in tropical latitudes, are incredibly productive energy sources with the proper investment). A short overview of century old experience is found below, in which one can recognize many of the contours of the world we exist in, at least if one replaces ‘British’ with ‘American’ –

‘On 14 April 1909, Burmah Oil created the Anglo-Persian Oil Company (APOC) as a subsidiary and also sold shares to the public.

Volume production of Persian oil products eventually started in 1913 from a refinery built at Abadan, for its first 50 years the largest oil refinery in the world (see Abadan Refinery). In 1913, shortly before World War I, APOC managers negotiated with a new customer, Winston Churchill, who was then First Lord of the Admiralty. Churchill, as a part of a three-year expansion program, sought to modernize Britain’s Royal Navy by abandoning the use of coal-fired steamships and adopting oil as fuel for its ships instead. Although Britain had large reserves of coal, oil had advantages in better energy density, allowing a longer steaming range for a ship for the same bunker capacity. Furthermore, Churchill wanted to free Britain from its reliance on the Standard Oil and Royal Dutch-Shell oil companies. In exchange for secure oil supplies for its ships, the British government injected new capital into the company and, in doing so, acquired a controlling interest in APOC. The contract that was set up between the British Government and APOC was to hold for 20 years. The British government also became a de facto hidden power behind the oil company.[6]

APOC took a 50% share in a new Turkish Petroleum Company (TPC) organized in 1912 by Calouste Gulbenkian to explore and develop oil resources in the Ottoman Empire. After a hiatus caused by World War I it reformed and struck an immense gusher at Kirkuk, Iraq in 1927, renaming itself the Iraq Petroleum Company.

In 1920, the APOC also acquired a northern oil concession that had been formally granted in 1916 to a former Russian subject, the Georgian Akaki Khoshtaria. To manage this new acquisition, the APOC formed a new subsidiary, the North Persia Oil Company, but the Iranians refused to accept the new company, giving rise to a lingering dispute over the northern Iranian oil.[7]

During this period, Iranian popular opposition to the D’Arcy oil concession and royalty terms whereby Iran only received 16% of net profits was widespread. Since industrial development and planning, as well as other fundamental reforms were predicated on oil revenues, the government’s lack of control over the oil industry served to accentuate the Iranian Government’s misgivings regarding the manner in which APOC conducted its affairs in Iran. Such a pervasive atmosphere of dissatisfaction seemed to suggest that a radical revision of the concession terms would be possible. Moreover, owing to the introduction of reforms that improved fiscal order in Iran, APOC’s past practice of cutting off advances in oil royalties when its demands were not met had lost much of its sting.

In 1923, Burmah employed Winston Churchill as a paid consultant to lobby the British government to allow APOC to have exclusive rights to Persian oil resources, which were subsequently granted.[8] In 1925, TPC received concession in the Mesopotamian oil resources from the Iraqi government under British mandate. TPC finally struck oil in Iraq on 14 October 1927. In 1928, the APOC’s shareholding in TPC, which by now was named Iraq Petroleum Company (IPC), would be reduced to 23.75%; as the result of the changing geopolitics post Ottoman Empire break-up, and the Red Line Agreement.’ https://en.wikipedia.org/wiki/Anglo-Persian_Oil_Company#Creation_of_APOC

29 Bill January 16, 2016 at 12:39 pm

It’s not much of a cartel if you dont have the ability to restrict output to raise price. What you might have is a talking club, blaming each other for not restricting output to support prices, while secretly undercutting the cartel, or vertically integrating into businesses where it is difficult to tell whether you have cut output or where you have the capacity to flood another market with product, such as chemicals and plastic compounds. Look for a race to have foreign investors build chemical processing plants in Opec countries.

30 prior_test January 16, 2016 at 1:54 pm

‘It’s not much of a cartel if you dont have the ability to restrict output to raise price’

The Saudis are doing the opposite – they are ensuring that most of their competitors are being slammed down by the Saudi decision to keep their export pipeline flowing at full capacity. Which means that in the middle term, the Saudis are likely to clean up when the price of oil rises again.

They are crippling two of their major rivals in Russia and Iran, and ensuring that the U.S. will lose its ability to reduce its reliance on oil imports any time soon (the U.S. currently imports more than 7 mbd – expect that figure to grow by something like a third in the next two years, at least if the price of oil remains below 50 dollars a barrel).

Being a swing producer comes with a different framework than being a member of a cartel. That the Saudis are now in a position to pull this off for at least the short term future is another example of just how truly skilled the Saudis are at riding the oil industry’s boom and bust cycle – Saudi oil is still cheap to produce, in comparison to Brazil’s or America’s or Norway’s deep water sources, or the Arctic resources Russia continues to count on, or things like Canadian tar sands or U.S. tight oil.

Of course the Saudis may make a misstep – but it would be the first since claiming 50% of Aramco’s profits for themselves in 1950 – https://en.wikipedia.org/wiki/Saudi_Aramco

31 Bill January 16, 2016 at 3:29 pm

The theory of predatory pricing to drive out rivals doesn’t work. Let’s say a fracker goes bankrupt, or an independent producer. After the dust settles, the assets are still in the ground, ready to be exploited as prices rise again.

As for disciplining rivals–Russia and Iran–that presumes that these countries do not have internal needs and would be willing to sacrifice them for “the long term”. Meanwhile, alternative energy sources and battery technology and higher MPG looms in the future.

Figure out the discount rate.

If you are interested in the dynamics of resource cartels, and their history, a good summary and also an analysis of OPEC ala the late 70’s is an FTC Bureau of Economics Staff Report on OPEC which goes through all of this.

Saudis benefited from the Iraq war and the Iranian embargo. If you think they are as strategic as you think, ask yourself why they let the price rise so high in the first place to attract entry. You will then understand the political and economic myopia of resource cartels.

32 Bill January 16, 2016 at 3:47 pm

prior,

A very good piece on enforcement mechanisms–how cartels self-punish–is Ian Ayre’s article on this subject. Here is the link: http://islandia.law.yale.edu/ayres/Ayres%20-%20Cartels.pdf Ayre’s, in addition to the FTC paper, points out buyer strategies that would forestall reemergence: for example, countries conditioning foreign aid for non-participation or granting exclusive access to buyer markets; development of internal swing capacity (strategic petroleum reserve), etc.

33 prior_test January 17, 2016 at 3:56 am

‘The theory of predatory pricing to drive out rivals doesn’t work. Let’s say a fracker goes bankrupt, or an independent producer. After the dust settles, the assets are still in the ground, ready to be exploited as prices rise again.’

Assuming the world requires the same amount of oil – which just might not be true in a decade or two. The Saudis are likely doing several things at once – including ensuring they have oil dependent customers for a longer time span.

‘As for disciplining rivals–Russia and Iran–that presumes that these countries do not have internal needs and would be willing to sacrifice them for “the long term”.’

The Soviet Union had experience at how effectively the Saudis can wield oil as a weapon in the marketplace. And to ask an honest question – is today’s Russia more or less able to ‘sacrifice’ than the Soviet Union?

‘If you think they are as strategic as you think, ask yourself why they let the price rise so high in the first place to attract entry.’

The Saudis and OPEC are two different entities, with different goals. At this point, it is quite obvious that the Saudis are playing by their own rulebook concerning oil production, and forcing the rest of the world to deal with it, since it appears the Saudis care about OPEC as much as Russia or Norway do at this point.

34 T. Shaw January 16, 2016 at 10:44 am

Here is a possible reason why declining gasoline and home heating expenditures don’t have sufficiently positive effects on the economy. It’s not higher income. Rising incomes likely would be better for growth. Related: 5% unemployment (one hundred percent bullshit number) generally would signal wage-increase pressure. Now we don’t see that. Wages are stagnant. The increases in employment are in low paying jobs, people living hand-to-mouth.

Of course, blame Bush.

35 LR January 16, 2016 at 10:50 am

It’s hard to argue that *in and of itself* a falling price of an economic input is a bad thing overall. Sure, it’s locally bad for those invested in it, but there is no way it can be bad globally in any plausible economy.

The really large declines are a result of over-investment and the inability to modulate drilling output with demand (expensive/impossible to start and stop wells, too expensive to store the stuff above ground). These capital intensive, resource extraction industries are certainly prone to boom and bust and wild price swings, no doubt. But that is not news. It has ever been thus.

There are hedging markets to hep alleviate this, but not everyone avails themselves of them. In fact a whole other side to this market was developed in the form of commodity indices to help consumers hedge their consumption exposure. That was blamed for prices being too high just about 7 years ago.

The banks invented this game and if they take capital markets losses so be it. It’s also hard to feel sorry for theocracies run by falconeers who have chosen not to modernize their countries.

With a commodity with a highly volatile price like oil there will be squealing at both ends of the price swing. It’s another reason besides carbon emissions to take a look at eliminating primary dependency on this type of resource.

36 ABV January 16, 2016 at 10:53 am

Looking out from inside the oil patch the answer seems easy. Cheap oil is great for everyone but producers. Given the relative speed of the dislocation lots of capital and labor is stuck in unproductive uses. Balance sheets have to be cleansed and economic inefficiencies have to be corrected.

Luckily this time around – unlike the 80s – junk bonds were the primary funding mechanism instead of banks. So as the industry contracts this time it won’t kick off a savings and loan crisis and bond holders should be more equipped to take haircuts without negative spillovers. But the market still has to adjust to the fact that they dropped hundreds of billions into completely worthless projects. To get an idea how inefficient capital deployment was, we have dropped two thirds of our rigs and production isn’t really declining. Lots of zero marginal rigs!

We have a few hundred thousand workers that need to move or change industries. That won’t happen overnight especially when many still haven’t been laid off and are twiddling their thumbs waiting for a price rebound or a pink slip.

Countries have been reducing or eliminating fuel subsidies. This temporarily lowers demand in high demand growth countries! Slows transmission of lower prices worldwide but is good in the longer run. Who thinks Nigerian states having to raise taxes and be accountable to citizens instead of central govt cronies is bad in the long run?

Energy deflation is what has powered many of our greatest growth spurts, everyone should be cheering! (Except me in Oklahoma?)

37 brad January 16, 2016 at 11:09 am

>> Energy deflation is what has powered many of our greatest growth spurts, everyone should be cheering!

Now imagine the growth we could have with housing deflation, which everyone spends an even larger portion of the income on.

38 ABV January 16, 2016 at 12:11 pm

I’ve long been disappointed that higher quality prefab houses haven’t been able to catch on and scale up. Though I have heard in China they are taking this more seriously especially for larger buildings. It would make sense they would lead in construction innovation since they are building so much so fast with little regulation.

Now the hope has to be for 3D printed houses and buildings to catch on. Combining that tech with wireless electric power, and floors that heat and cool by resistive heating or the peltier cooling (with a very tight envelope to limit energy needs in the first place) could drastically simplify the mechanical aspects of the home and drop the cost and construction time. How low does the cost per square foot have to go before older homes start getting torn down? Maybe $50?

Of course construction costs more matter in non coastal places. 3D printing houses isn’t going to help the price much in San Francisco.

39 brad January 16, 2016 at 12:48 pm

What’s need in coastal cities is better government policies not better technology.

40 ABV January 16, 2016 at 1:20 pm

True. Luckily I don’t live in such a place so its not really a concern for me or my community, which biases my views.

41 rluser January 16, 2016 at 3:15 pm

There is a very large stock of sub $50/ft^2 residential housing in the U.S. not being destroyed, but actively maintained. It must be lower.

42 Economist January 16, 2016 at 11:37 am

I think your point at the end make more sense. It is more an information story. Oil prices crash -> signal that the demand conditions are really poor.
Obviously supply has played a major role (shale, opec non-action). But the extent of the drop suggests a demand side story as well.

43 Benny Lava January 16, 2016 at 12:56 pm

Instead of looking at supply side, what about demand side? Is it possible that consumption is down in China, and relatively flat in stagnant Europe and the U.S.? Thus the big drilling boom of the last few years was misspent? Would this be evidence that things in China are as bad as Tyler says?

44 prior_test January 16, 2016 at 1:58 pm

‘Would this be evidence that things in China are as bad as Tyler says?’

Yep – but not completely conclusive evidence, as the Saudis are playing a game with multiple goals, including crippling American fracking, Russian production, and Iranian profits available to be spent on opposing the Saudis. That the world will remain dependent on oil at a lower price is just icing on the cake, from the Saudi perspective, as demand at 30 dollars a barrel is likely to be fairly strong, regardless of economic growth.

45 Benny Lava January 17, 2016 at 11:30 am

So you’d conclude that:

A)The Saudis are still swing producers, and Twilight in the Desert theory being false

B)The Saudis are playing the long game

Is this correct?

46 Tom Warner January 16, 2016 at 12:56 pm

The part about producers actually reducing their spending by a lot isn’t controversial. There’s especially strong links between the oil price and industrial commodity demand because oil producers tend to use high prices to splurge on building. What’s controversial here and rightly called speculative is the idea that that outweighs the boon of lower costs to consumers. Merely stating the former doesn’t take us anywhere towards proving the latter. Krugman’s idea that falling oil prices make advanced economies more vulnerable to deflationary woes is goofball. Europe is doing better than expected, and it’s obviously thanks to cheap energy.

I would separate the initial oil price shock a year ago from what we’re seeing now, which is parts demand and supply related. There are indications piling up of a global growth slowdown centered in China, and equities are optimistically priced. Besides we’ve had a January slump three years in a row now, there may be something more mundane and technical going on there.

47 Rex January 17, 2016 at 1:24 am

This sounds like my thesis too.

1. The oil market is well understood – it’s oversupply – no mystery there.
2. What isn’t understood is how bad it is in China. No one really knows …..

I think it’s misleading equities are mirroring oil’s swings. The fear in the market is China.

48 Scott Gustafson January 16, 2016 at 1:01 pm

Based on some rough calculations, in the US we were spending about 3.4% of GDP on crude oil for much of the period between 2011 and 2014. With the drop in price in 2015, that expenditure has dropped to about 1.4% of GDP.

That’s a really big positive aggregate supply shock to the economy.

Note that crude oil demand (gross inputs to distillation units) increased slowly over that entire period for the US.

49 Derek January 16, 2016 at 1:33 pm

Three thoughts.

High prices were driven by high demand. These low prices represent the oversupply vs. demand. Prices are information, and any numbers out of the various government statistic generators will lag. We are into a serious downturn. The financial markets will be affected; there are lots of other things showing the same thing.

The oil industry requires substantial financial resources, and the writeoffs will be large.

Third, and this is in my mind the most interesting, and particularly salient as where I live not too far from Calgary, and I have a surprising number of acquaintances who work there or commute to jobs in the oil patch.

The drivers of job growth and prosperity in many western countries including the US has been from energy and commodity development. Cheap fuel as money in consumer’s pockets doesn’t seem to be driving demand; at least not enough to offset loss from the jobs and activity that has been lost. How many western countries will face government debt pressures? I think Canada will, up to and including defaults. Depends how long this goes on. The $20 oil in th 80’s lasted quite a while. If I owned Ontario debt I would be getting nervous.

I was talking to a friend last night who said this is the third oil downturn he has seen. It was a pretty good run, 1992-2015, far longer than most commodity runs. It goes off like a light switch.

Imagine Google, Microsoft, Facebook, etc. all coming out with horrible numbers at the same time. Thrre would be a mass diving under the furniture, not because San Francisco would have high unemployment. Because they provide services that run lots of the economy, and would presage a serious downturn. Same here.

50 Steve Sailer January 16, 2016 at 6:26 pm

It used to be that falling gasoline prices meant that working class people would buy more pickup trucks and get more jobs building houses in the exurbs.

Has that mechanism broken down? Does everybody assume that higher wages and prosperity is permanently out of the grasp of the working class?

51 chuck martel January 16, 2016 at 8:19 pm

Both US and Saudi oil production are pretty close to their historical levels. It’s recently developed Russian capacity that has flooded the market. Unless their rig hands work for free they are in more trouble than anyone.

52 brickbats and adiabats January 16, 2016 at 9:21 pm

Only if you stretch the definition of “historical.” US production is close to 1970s levels, so “historical” in that case doesn’t mean “recent history.” Saudi production has remained steady but they’re now believed to be pumping at maximum rates (and were in the aughts too, with no spare capacity). Russian capacity? West Siberia has been in decline for the better part of a decade. Recent increases in output have been from the US and Iraq.

53 ashby January 17, 2016 at 6:06 am
54 chuck martel January 17, 2016 at 11:00 am

The lines on the graph depict two different things. The “Saudi America” line shows not only crude production but natural gas and refined products so some of it is counted more than once. The “Saudi Arabia” line refers to crude production only.

” This energy bonanza in the US — described as the “energy equivalent of the Berlin Wall coming down” — would have been largely unthinkable even six years ago. But then thanks to revolutionary drilling and extraction techniques that were developed by American “petropreneurs” and are “made in the USA,” vast oceans of previously locked shale oil and gas have been accessed across the country, making the US the world’s No. 1 petroleum producer for 29 months running.”

There’s nothing new or revolutionary about the drilling and extraction techniques. Shale oil production became possible because oil prices were high and expensive fracking became economically viable. Now that prices have dropped, further fracking activity has slowed dramatically.

http://bismarcktribune.com/news/local/govt-and-politics/oil-production-rises-despite-low-rig-count/article_bee52d7b-7dd8-5698-afc9-e0974878c18a.html

55 chuck martel January 17, 2016 at 12:07 pm
56 Philip George January 17, 2016 at 1:42 am

I think there is a simple monetary explanation for the fall in commodity prices, the fall in stock prices, and even part of China’s problems. If you see the graph on http://www.philipji.com/item/2015-12-05/the-fed-is-set-to-squeeze-during-a-monetary-contraction you will see that money supply (my measure) has been contracting (relatively speaking) since January 2014.

The initial effect was on commodity prices and then on stock prices. I am sure other asset markets will soon feel the contraction. Even US imports from China have not been rising as a result, which must contribute to China’s problems. See https://research.stlouisfed.org/fred2/series/IMPCH

By the end of this year I am predicting a meltdown in one or more financial asset markets followed by a recession next year.

57 ashby January 17, 2016 at 2:50 am

Has anyone quantified the impact of all these sovereign wealth funds liquidating to cover their countries budgetary shortfalls? Wouldn’t that in and of itself cause a downdraft on the global stock markets? (Especially in combination with the Chinese decline and attendant deflation of commodities?) Then roll in deleveraging…

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