Losing Steam

Resources: Energy

Originally published in the February 2007 issue

Most economic commentators have been happy to cite the recent fall in energy prices as a reason to be optimistic on the economy in 2007. Some have heralded the decline as a ‘tax cut’ for Western consumers, others have argued that it means central banks will be less keen to raise – or even quicker to cut – short term interest rates. All told, it is regarded as a cause for rejoicing for everyone other than investors in commodities – but is this really the case?

Confounding earlier expectations of an impending ‘superspike’ and seriously annoying the millennialists of the ‘Peak Oil’ crowd, crude has fallen some $20 to the mid $50s a barrel, a level first seen back in the spring of 2005.

With record levels of drilling activity boosting onshore production in the States and with inventories swelled to bursting by the unusually mild winter we have so far enjoyed, Natural Gas has begun another probe back towards the four year lows briefly touched in late September.

As a result, US, Big Sandy Barge coal, too, has fallen 35% from its March highs to revisit levels last seen in early 2004 and previously attained as far back as 2001. Though rather uncomfortable to those invested in commodity indices – especially the less well balanced ones weighted more to energy which have suffered losses during the closing four months of the year on a par with those registered in each of the 1991 US regional banking crisis, the Asian Contagion, and the aftermath of 911.

But, what’s sauce for the goose is sauce for the gander is it not? If commodities are suffering a period of retrenchment, investment opportunities surely abound elsewhere?

On the face of it, can one have any quibbles with the mainstream idea that the recent fall in energy prices represents an unmitigated positive for the world economy? After all, a relaxation of the degree of scarcity of the ‘ultimate resource’ cannot fail to be a boon can it?

Ultimately, the answer is, indeed, a resounding, ‘No!’ To see this, just imagine the untold human benefit which would ensue if some miracle of technology were instantly to create an inexhaustible, ubiquitous source of supply of energy, making this most precious of entities just as much a ‘free good’ as is the air whichwe breathe.

However, as soon as we quit the ivory tower of theory, we need to take a few caveats with us into the grimy streets of everyday reality for, as with all things economic, the short run impact of such a decline cannot fail to be both context specific and path dependent, while, in our hyperactive global casino, we also need to consider the financial ramifications of the move

As with all sharp price changes – both positive and negative – there will inevitably be a disruptive element involved as entrepreneurial calculation goes awry and leads to the post hoc revelation of a good deal of misallocated capital and unrewarded effort, much of which will either be hopelessly irremediable or, at best, only retrievable at the rate of some lowly number of cents on the dollar.

“On the face of it, can one have any quibbles with the mainstream idea that the recent fall in energy prices represents an unmitigated positive for the world economy?”

Once this happens, incomes will fall and assets dwindle in value and so, in turn, the customers of those harmed by the decline will bear their own burden of hardships as the ripples spread outward. Think here of what happens to a saloon keeper when the nearby gold strike runs out.

Conversely, of course, those who were previously struggling to pay the former higher prices will receive a boost to their disposableincomes and so, gradually, will spread the windfall to their own, possibly quite distinct suppliers of goodsand services.

Again, though this may lead to an undeniable long term benefit, the winners and losers will not be identical, nor will the redistribution of favours be instantaneous, or even smooth. Here you only have to think of the side effects of superior Japanese automotive technology, or cheaper Chinese consumer goods production on the communities of manufacturing workers displaced from the West’s

rusting car plants and antiquated textile mills. ‘Frictional’ unemployment can easily harden into something more chronic in such circumstances, leading to persistent economic anaemia, especially where the interventionist welfare state has introduced all manner of institutional rigidities and perverse incentives to individual adaptation to these drastically changed circumstances.

Moreover, such upheavals usually serve to reveal the weak points among the creaking hinges ofour highly flawed monetary arrangements – something which may be of more import than is widely recognised when we take into account the crucial triple interaction of the dollar exchange standard, petrodollar ‘recycling’, and central banks’ near unanimous focus on controlling ‘core’ measures of CPI.

Indeed, it is with this last constellation of factors that we could make a contrarian argument that the current softness in energy prices may not constitute an unqualified positive for either the real or the virtual economies of work and speculation, respectively.

To begin to explain our little gedanken experiment, let us start from the fact that the world’s central banks remain happy to accumulate surplus dollars as a basis on which to inflate their own provision of reserve assets, thus allowing history’s largest ever profligate nation to run a ‘deficit without tears’ – as Jacques Rueff pungently termed it in the early 1960s.

If you doubt this, consider that between them, in 2006, foreign central banks’ custody accounts at the NY Fed (themselves only a subset of total dollar assets held) increased by the sum of $245 billion – roughly comparable to the size of the nation’s entire crude oil and natural gas import bill.

Put another way, estimates from such sources as the IMF, the IIF, and private forecasters peg the size of the GCC oil exporters’ current account surpluses for 2006 at around $250 billion, and that of all non OECD oil exporters at $500 billion (with perhaps another $100 billion to throw in, courtesy of Canada and Norway).

Even this does not tell the whole story, for the surplus is, by definition, the residual left after we deduct expenditures on imports. The best guess at what these might total comes within spitting distance of reaching a hefty $1.5 trillion – up by fully two thirds from 2002.

A study of the admittedly patchy official data, conducted by the NY Fed, estimates that of this $1 trillion increase in receipts, roughly half has gone to buy more goods and services from abroad, while the remainder has been ploughed into acquiring assets of all kinds.

Broadly speaking, the NY Fed researchers reckon that, for each extra $1 of imports from the main energy producers, the three main energy consumers – China, Europe, and the US – have seen the return sales of goods made to their suppliers increase by around 60¢, 40¢, and 20¢, respectively. Thus, the rise in oil prices has arguably helped power both Chinese low value added industrial expansion and the renaissance in capital goods and engineering witnessed in Europe (German exports have risen nearly 80% in US$ terms, and the country’s surplus has gained 55%, more than overcoming the Mittlestand’s handicap of a one third rise in the euro over the last four years).

As for the poor, old, hollowed out US, the low level of reciprocity tells its own tale and serves to reinforce the lesson of the custody accounts: namely, that petrodollar recycling here has mostly represented nothingmore than a giant vendor finance scheme – albeit one with complicated monetary side effects for the exporter nations themselves.

This last comes about thanks to the ‘childish game of marbles’ – as Rueff, again termed the automatic recycling of money from creditor to debtor nation. This is a highly inflationary mechanism, since each turn of the system generates new monetary reserves in the surplus country without producing a corresponding reduction in the deficit country, thereby removing the self regulatory element so crucial to the workings of the classical gold standard.

Nor are floating exchange rates given reign to bring about their own, more brutal governing mechanism, for not only do many of America’s current suppliers of finished goods work to prevent the escalation of their own currencies’ rice vis à vis the dollar, but a goodly proportion of the world’s energy exporters also either link the local unit explicitly to the greenback or else have a ‘sterilisation’ mechanism in place to forestall its too rapid appreciation.

As the last daisy in this childish chain of folly, we have the current orthodoxy by which central bankers focus blindly on managing ‘core’consumer price indices over a politically convenient, but ill-defined ‘medium term’ while either paying little more than lip service to (or openly pooh poohing) the idea that the excess credit simultaneously being generated is anything other than a whim of the mass consciousness to forego sizable gobbets of possible present consumption a chimera which masquerades under the name of the ‘global savings glut’.

In its basic form, the errors intrinsic to such a Fisherian fallacy of ‘price stability’ are that it manages to overlook the obvious conclusion that in an era of far reaching, supply side improvements, such as we are witnessing today prices should actually be falling, not rising at a historically deplorable few percentage points a year.

But, what is worse, the unholy trinity is made into even more of a Faustian bargain by dint of the fact that most policy makers also have a penchant for stripping out every rise in their chosen price index which is directly associated with higher oil prices, per se (in favour of waiting for so called ‘second round’ effects to become manifest).

The dire consequence of this is that the monetary authorities are thereby doomed to monetise those very same price increases, deferring or postponing the hard choices between alternatives which their appearance should demand of energy users, and so impairing the ability of the market system to adapt properly to the change.

This combination of flawed institutions and shallow economic reasoning means that a higher price of energy no longer sets in train what, at best, should amount to a zero sum game of winners and losers (at least at the very simplistic level whereby we assume a rapid and near costless rearrangement of labour and capital, as discussed above).

Rather, rising prices for oil and gas, in particular, now act as the greatest and most pervasive Keynesian stimulus mechanism to be seen outside of the Military Industrial complex, or absent the next, deliberately fostered global housing bubble.

Thus, in a year when monetary policy was supposedly being tightened, we had the spectacle that 2006 saw $7 trillion in new debt issuance, the sale of $700 billion in new equity related instruments, and the syndication of $3.9 trillion of new bank loans (each one and many of their high risk subsets representing new records) without this $11.5 trillion total, $45 billion per trading day, call on the pool of investible funds acting as the slightest impediment to the delivery of an impressive rise in prices and a ground breaking decline in associated quality spreads, in the vast majority of world markets.

Thus, in a year when margins were supposed to be squeezed, Japanese and European companies were doing very nicely, thank you, while the third quarter of 2006 saw US non financial corporateprofits hit new highs with manufacturers’ earnings per dollar of sales reaching their best levels in the 21 year statistical record.

Intriguingly – if in a manner a little too pat for taste – signs of moderate distress in the latter sector have only manifested themselves since energy prices began to fall in late summer.

Overall then, based on this set of slightly off the wall premises, we might argue (with tongue only partly in cheek) that our present world financial system is set up so that:

* dearer oil and gas automatically leads to the seamless creation of the vast pile of new dollars with which to pay for it;

* that this promotes faster central bank reserve accumulation and, thence, more rapid, counterpart currency monetary infusions (ie higher inflation, properly defined). This is all the more unavoidable in that such a vast preponderance (c.90%) of energy assets are now either state owned or controlled and so the disposition of revenues therefrom has become a matter for direct policy prescription and not one subject to the dictates of entrepreneurial choice;

* that some portion of all this extra ‘liquidity’ goes towards generating an upsurge in orders for machinery and equipment in the industrialised West, and for non energy commodities in general (driven variously by the secular trend of ‘urbanisation’; by the launching if only because of a perceived lack of alternatives – of vast, prestige infrastructure projects; or arising out of the less irrational desire to ‘diversify’ the exporters’ industrial base as they deplete their resource patrimonies);

* and, finally, that it delivers rampant asset price inflation in all its hydra headed forms from modern art to Manchester apartments, from vintage wines to Vietnamese warrants, and through the whole financially engineered alphabet soup of PIKs, ETFs, LBOs, CDO squareds, et al.

Given all this, it might therefore be apposite to conclude by returning to the question we set ourselves at the start of this discussion, namely: can the fall in energy prices fail to be a boon? Perhaps, from the perspective of the Lumpenspeculatoriat which so dominates our professional milieu and which is so looking forward to repeating its triumphs of 2006, the answer is a resounding: “You bet it can!”


Sean Corrigan is Chief Investment Strategist at Diapason Commodities