The Swift and Violent Rise of Oil

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Today’s Daily Reckoning comes with a warning. If you have a short attention span, dislike history and metaphors, have atrocious spelling and grammar, or otherwise would just prefer to be told what to do with your money and life, then stop reading now and go have a beer. Have one for us as well.

If, on the other hand, you want to know why oil prices could double this year, or how $52 trillion in total global debt will utterly suffocate central bank attempts to resuscitate bank lending, or Ben Bernanke’s secret plan to turn trillions of dollars worth of toxic assets into shareholder equity, read on!

You’re still with us? Good. Now, why are oil prices lying?

Prices communicate information. The NYMEX February oil contract fell over 5% today in New York trading to $34.40. This suggests oil is falling in value, at least in the short term. And maybe that’s not totally a lie.

After all, the current oil price results from two factors. First, the absence of leverage from the oil futures market leaves prices reflecting immediate supply and demand. With inventories full, the market seems well supplied (so much so that OPEC is cutting production). Second, the reality that oil demand will be flat or slightly fall this year because of the worldwide financial pandemic.

Adequate supply plus stagnant demand equals $35 oil. So why is the December 2010 oil contract trading nearly 80% higher at $61.80? What could possibly happen between now and December 2010 that would cause oil to go up 80%?

Well, for one thing you might be in the early stages of an economic recovery by then. Demand would have recovered. Shares could be higher. Everything could be fine.

But we can think of at least three reasons why the current oil price is headed much higher this year (not in 2010). First, the lower oil price is actually going to lead to lower oil production later this year and next. Oil production is declining to begin with. But the crash in prices has put the kibosh on exploration and production.

Second, as Diggers and Drillers contributor Mike Graham explains in a January article on the subject, the clear trend within the oil market is that historical exporters are exporting less oil. There are several reasons for this, which Mike gets into in his story.

One is that oil exporters are hoarding it now and waiting for higher prices later. Another is that oil exporters are consuming more of their own production, leaving less for export. And still a third reason is that the world’s largest oil exporters face declining production trends thanks to…you guessed it…Peak Oil.

Yes. Peak Oil has not gone away. It’s been sent to the corner while the Credit Depression hogs the stage. But Goldman Sachs oil analyst Jeffrey Currie issued a report yesterday predicting a, “swift and violent rise” in oil prices in the second half of 2009.

Currie told a conference in London that, “”Thirty dollar oil reflects the same imbalances that got us to $147 oil. The problems haven’t gone away. We still believe the day of reckoning is to come.” What problems?

There are still major infrastructure bottlenecks in the global oil network. Currie says that despite the big fall off in demand, “This is not 1982-1983 all over again. The supply picture’s radically different…the demand picture’s radically different. The key difference is that today there are no large-scale next generation projects that are going to save the world. Commodity demand is exponentially higher than it was.”

This brings us to the third reason oil prices should rise later this year: the oil trade is back on. Sure, credit may still be a scarce commodity. But if you judge traders by their actions, you can see the market is setting up for a big oil back draft. As evidence, Bloomberg reports that, “Morgan Stanley hired a super tanker to store crude oil in the Gulf of Mexico, joining Citigroup Inc. and Royal Dutch Shell Plc in trying to profit from higher prices later in the year, two shipbrokers said.”

Our friend Dan Amoss back in America calls this the oil arbitrage trade, where supply is stockpiled offshore, and thus withheld from refiners, allowing existing gasoline inventories to be worked down. Then in six to twelve months time, when crude prices have moved higher, you simply park your ship at the terminal and cash in on the difference between what you paid six months ago (today) and the new market price.

It is normal for the oil futures to be in contango, where spot prices are lower than futures prices. What’s less normal is the amount of oil being stockpiled offshore. “Frontline Ltd., the world’s biggest owner of supertankers, said Jan. 14 about 80 million barrels of crude oil are being stored in tankers, the most in 20 years,” Bloomberg ads.

We also suspect that oil as an inflation hedge will come back into vogue later this year, which might be adding to the appeal of buying today at bargain basement prices. What’s more, you can never discount (although you can never fully quantify) the geopolitical aspect of oil prices. A good general rule of thumb is the more war there is in the Middle East, the more likely oil is to go higher.

So what should you do? That’s the subject of the January issue of Diggers and Drillers. More on that after we publish it for subscribers first later this week.

Next is a massive topic we are reluctant to introduce today. But we have to. There is no other way around it. It begins with a question: how much air is left in the credit bubble?

Actually, the question comes via Howard Ruff and Steve Hochberg. Let’s start with Hochberg.

He’s the lead analyst at Elliott Wave International. Bob Prechter’s folks have been forecasting for years that the collapse of the credit bubble would lead to a general and massive deflation, including much lower gold prices. In his latest analysis, courtesy of a DR Reader, Hochberg explains:

“The systemic build up of total market credit is so large, currently about $52 trillion, that its implosion will swamp the Fed’s attempts to inflate. And as CTC [Conquer the Crash] discusses, the remaining dollars that are not extinguished through bankruptcy, restructuring and write-offs, will increase in value. The thirst for cash will be insatiable relative to all other assets.

“Initially, the Fed’s attempt to inflate was akin to using a garden hose to refill Lake Mead after the Hoover Dam collapsed. Over the past five months the chart shows that the Fed has graduated to a fire hose. But creating just over $2 trillion in the face of a contracting pool of $52 trillion in total credit market debt is just not going to get the job done, and the only thing getting hosed right now is us.”

” Eventually credit will contract to the point whereby the income generated from economic production will be able to sustain it and at that point, yes, the U.S. dollar should indeed collapse of the weight of all the Fed’s machinations and gold should soar. But before the market arrives at that point, deflation must run its course. In our opinion, there is still a long way to go.”

But how far? A lot depends on the composition of that $52 trillion in credit. It can’t all just vanish can it? But how much of it is securitised by relatively stable assets? And how much of it could potentially melt away under the intense heat of deflation?

This is not an easy question to answer. But it begins with knowing what you’re dealing with. Specifically, you have to know who owes how much, and who owns how much. Those are two different questions. Let’s deal with the first one. And we promise we’ll make this as painless as possible. If you want to review this data yourself, by the way, you can find it here.

Keep in mind this data deals just with the U.S. And keep in mind it is government data. But the general question is this: how much deflation is left in the credit bubble and who stands the most to lose from it?

The Fed breaks up the total credit market debt outstanding into three categories: Domestic Nonfinancial Sectors (households, farms, nonfinancial corporations, state and local governments, and the Federal government), Financial Sectors (commercial banking, REITs, broker dealers, savings institutions, Government sponsored enterprise, Agency and GSE pools, and issuers of asset backed securities), and finally, the rest of the world.

What we find is that $32.9 trillion in credit market debt outstanding, as of the third quarter in 2008, was owed by the domestic non-financial sector. That’s 63% of the $52 trillion total. Households are on the hook for most of that, with $13.9 trillion owed (or 26% of all credit market debt outstanding). That would mostly be home mortgages we reckon.

Next within the financial sector are non-financial corporate businesses with $7 trillion, non-farm corporate businesses at $3.7 trillion, state and local governments at $2.2 trillion, and the United States Federal government at $5.5 trillion.

So what does it tell us? Well it tells us that if U.S. house prices continue to fall, there is a lot of room left to deflate in the credit bubble, at least several trillion dollars. It’s not hard to see this happening, given the rise in foreclosures, the prospect of even less federal funding for refinancing of mortgages, and the sudden collapse of America’s banking model.

But the lack of credit for refinancing and the looming wave of Alt-A recasts this year and next is, in some sense, already old news. What also keeps us up at night is the $16 trillion in credit owed by the financial sectors. How much of that is at risk to further deflation?

You can get an idea by looking at the L2 table on page 59 of the Flow of Funds report. There is $6 trillion in corporate bonds outstanding. Nearly $5 trillion in Agency and GSE-backed securitised mortgage pools are on the books, and another $3.1 trillion in GSE debt itself. This does not include $1 trillion in “other loans and advances” which may or may not include home equity lines of credit.

We’re sure you get the picture by now. There is still at least $8 trillion housing related assets owed by the financial sector. That might be kind of tough to pay off, given the falling value of the assets which securitise that debt. So who stands the most to lose if households can’t pay their mortgages, corporations default on their bonds, and housing-related assets held by financial corporations continue to fall?

The financial sector combined holds $37 trillion in credit market “assets.” It owns $37 trillion in other people’s promises to pay. Those promises, all $37 trillion of them, are on the books at face value. What’s more, U.S.-chartered commercial banks (Citibank, Bank of America for example) own $8.2 trillion in credit market “assets.” Life insurance companies own another $2.9 trillion. Money market mutual funds own $2.1 trillion in credit market assets, while mutual funds own $2.3 trillion.

Do you see what we’re getting at? The institutions that have the most to lose from a fall in the value of their credit market “assets” also have large obligations to shareholders and pensioners. Those institutions are counting on those assets to meet their own future liabilities (which do not fluctuate in value). And households are relying on those assets to retire, or in some cases, to live month-to-month on a fixed income.

Someone is going to lose, somehow. Or everyone will.

Households win if the value of the credit they owe (their mortgage) is written down or managed lower by some new law. But investors counting on that asset (often the household itself through a pension or life insurance) don’t win if the amount they are owed is arbitrarily reduced.

Either way, Prechter’s group is probably right. There is more deflation ahead. A lot of it. And not just in housing.

The corporate bond market would be another place to look. Corporate defaults haven’t begun to rise noticeably yet. But faced with a much slower economy and much higher borrowing costs, it’s going to be tough for highly indebted firms to roll over their debt, much less take on anything new. Dividends are already being slashed here in Australia.

And where does the deflation of the $52 trillion credit bubble leave us? Well Howard Ruff reckons we get a period of serious deflation, punctuated by a period of hyperinflation. Over at Kitco, he writes that, “First, we will continue to plunge into a major deflation period which will be characterized as a ‘recession,’ and later in the year as a ‘depression.’ Deflation and inflation are always monetary phenomena.”

“Second, deflation will evolve into a run-away-hyper-inflationary depression because of what government will do to try to prevent deflation, which is synonymous with depression and has overtones of the 1930s.”

How will government accomplish that? More on it tomorrow. Meanwhile, and finally, some timely reader mail.

“why do your emails have to be so long winded…. they waffle on toooo [sic] much, one metaphore [sic] after another… can any one really be bothered in there busy lives readin [sic] over all that…. I actually find some of the factual input useful, but there isnt [sic] much of that… a friendly tip, cut your newsletters/emails by 80%, get to the point and lose the metaphores [sic] and long winded useless stories…. the genuine potential investors your trying to pull in wont [sic] be inpressed [sic] with such dragged out point of views…I am a member of a well known share forum, many think the same as I do… the dailyreckoning could do allot [sic] better, it has so much potential, yet your [sic] boring people…”

Zzzz. Huh? What’s that? Oh yes, this free daily e-mail about world historic financial events is too long and won’t impress interested investors.

First, a tip. Maybe you should spend more time on spelling and grammar. But that is beside the point.

Sure the Daily Reckoning can be long. And we’re grateful that you invite us into your living room and office each day to hear what we read. We don’t take your time for granted, which is why put time and effort into what we write. And some times it takes time and effort to unwind a complicated subject.

If we had more time, the DR would be shorter. And in fact, we’d like to launch a subscription-based DR later this year. It would be a shorter, more to-the-point version of the DR with action to take. But in the meantime, we don’t have the time for a shorter DR! So you’ll have to deal with the long one. Or watch television instead. Your choice, if you’re still reading that is.

Dan Denning,
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Dan, I can hardly think of a wasted sentence in your articles. Sure, they can be long but lately they have been excellent reading. I find myself at the end of each article wanting to read on.

    What I could suggest though is that you started off talking about Oil, and then went to US financials…maybe split it into two articles?
    I read them all anyway so it doesn’t matter to me, I guess it would be it easier to read for others if it is broken up.

    Incidentally, how relevant is ‘Conquer the Crash’ to our current situation? Written in 2003, it must be quite Nostradamus-esque if it is still highly applicable.

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  2. Love your work Dan. Just a lurker, watching the world unfold. Hope your stuff will still be online, perhaps delayed, should you go to a subscription model.

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  3. Dan, I agree with Pete. Sure the articles can be long but never a word is wasted.

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  4. What the Pittsburgh Steelers predict for the stockmarket:

    History suggests that the Dow Jones Industrial Average is on the cusp of a 70%+ rally over the next couple of years. It may even pass the 2007 high.

    Two examples from history are 1975 for the 70%+ rally and 1927 for the new Dow Jones high.

    The Pittsburgh Steelers won the super-bowl in 1975 after the Dow made its recession low in December 1974. From the December 6 low the Dow rallied 75.69% to top on September 21, 1976.

    “Bush is the first president since Richard M. Nixon to preside over a net fall in stocks during his term” (Leah Schnurr, “Wall St rises on energy gain, financials cut losses”, reuters.com, January 16, 2008).

    “President George W. Bush is the first president since Richard Nixon to preside over two recessions” (Emily Kaiser, Recession started in December 2007: panel, reuters.com, December 1, 2008).

    [The recession of 1973-75 was the severest of the two that occurred in Nixon/Ford Republican Administration just as the present recession is the severest for the Republican George W. Bush].

    The Steelers have made it to the super-bowl this year, after the November 2008 Dow Jones low in the present US recession.

    The high in 1976 was 1,014.79 – only 36.91 points below the 1973 nominal high of 1,051.70.

    In this scenario history suggests that a yet future recession, leading to depression, will have its severest impact in a Republican administration to follow the Obama admin., in 4 years time.

    The second example is based on that historic precedent that a ‘global’ crisis often precedes the final rally of a sharemarket bull run.

    The Central Bankers’ intervention in December 2007, as a result of the latest financial crisis, had echos of 1927 and 1997-98. This suggested then that the present crisis was not going to be the crisis that tipped the world into depression.

    This also implies that we are not yet at the debt-saturation point of the upwave of the present debt/credit cycle, just as 1927 was two years away from the debt-saturation point of the 1920s’ sharemarket bull run.

    (The debt-saturation point of the “upwave” was in 1929 when total credit market debt as a percentage of GDP was 176%. In 1933 it was at 287%. It was not till January 1953 when this debt, at 129%, was down to manageable levels, which then began the present “longwave” credit/debt cycle.

    History suggests that the present Central Bankers’ intervention will not only lead to recovery but will propel the global economy to the next “upwave” debt- saturation point of the latest long-run credit/debt cycle.

    This then implies that the Central Bankers will be basically powerless, when the next serious crisis occurs in the rally ahead, to prevent a debt-deflation depression, which is needed to help bring debt down to manageable levels.

    Below are some quotes, three of which I have quoted before, in regard to 1927 and the post crisis rally that may ‘rhyme’ in the future, even if the Dow Jones does not take out a new high, and the Steelers do not win on February 1:

    [Recession: October 1926 to November 1927].

    “… the Federal Reserve promptly began its great burst of expansion and cheap credit in the second half of 1927. This period saw the largest rate of increase of bank reserves during the 1920s, mainly due to massive purchases of U.S. government securities and of bankers’ acceptances, totalling $445 million in the latter half of 1927…” (Kevin Dowd & Richard H. Timberlake, Money and the Nation State, (Edison, Transaction Publications, 1998, p.144)].

    “Wall Street greeted the lowered [discount] rate [of August 5, 1927]. It meant businesses could borrow funds more easily, and so expand operations and profits. More important, it assured a continual flow of cheap credit for the call-money market. Member banks were able to borrow money from the Federal Reserve at 3.5 percent and then lend it as call money at 5 percent, making an easy profit of 1.5 percent. Thus, the international situation was resolved in such a way as to encourage speculation on Wall Street” (Robert Sobel, Panic on Wall Street, (New York: Macmillan, 1968), pp.360-361).

    “The major stock market boom on Wall Street coincided with a virtual suspension of new international lending and a retreat of capital. New money from America stopped going to Germany, Latin America, or Central Europe in June 1928. All the hot money went to Wall Street instead. And much more foreign money, especially English money, was also attracted by high returns as compared to bleak prospects elsewhere” (James Dale Davidson & William Rees-Mogg, The Great Reckoning, Revised Edition, London: Sidgwick & Jackson, 1992, p.207).

    “Adolph C. Millar, a dissenting member of the Federal Reserve Board, subsequently described this as ‘the greatest and boldest operation ever undertaken by the Federal Reserve System, and…[it] resulted in one of the most costly errors committed by it or any other banking system in the last 75 years’. The funds that the Federal Reserve made available were either invested in common stocks or (and more important) they came available to help finance the purchase of common stocks by others. So provided with funds, people rushed into the market. Perhaps the most widely read of all the interpretations of the period, that of Professor Lionel Robbins of the London School of Economics, concludes: ‘From that date, according to all the evidence, the situation got completely out of control'” (John Kenneth Galbraith, The Great Crash 1929, (London: Penguin Books, 1992), pp.38-39).

    “Indeed the temporary breaks in the market which preceded the crash [of October 1929] were a serious trial for those who had declined fantasy. Early in 1928, in June, in December, and in February and March of 1929 it seemed the end had come” (Galbraith, p.98).

    History then suggests for stockmarket gamblers that they are on the cusp of one of those ‘best-buy ‘ opportunities (eg. 1927, 1974, 1982 and 2002) which will eventually end similar to 1930-32 – where the Dow declined 86%.

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  5. Ditto what Pete said, keep up the good work guys. I dare say our fellow reader up there is lamenting the bygone days of the tech bubble where you could throw a few thousand in an IPO and then sit back and plan your next holiday!

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  6. I think Watcher7 says keep up the good work, the budget references and the great network of sources … I do.

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  7. Dan,

    I’m puzzled by your support for the theory of Peak Oil. It seems to me that this theory belongs with the predictions of Thomas Malthus, on the scrap heap.

    While it’s true that there is only a limited amount of oil in the world and that therefore production must eventually reach a peak and decline, that only addresses the supply side of the equation, and only in part. It could make a difference in the short term, but the shorter the term you are using to judge it is, the less impact it can make.

    Over a longer term, one must also look at demand. As prices rise, demand contracts. People start taking public transport more often, car-pooling, or switching to hybrid or electric cars (which are fuelled, ultimately, mostly by coal or uranium). As prices rise, demand falls, over the medium and long terms. Further, demand switches to alternatives that, like uranium, have much greater reserves.

    The price rises also affect supply. Suppliers pump their existing facilities faster. Alternatives to drilled oil that are more expensive to produce, such as oil/tar sands, deep-sea oil deposits (if they exist) and biodiesel, become economically viable, increasing supply. Supply does not necessarily increase sufficiently to replace that which has been lost, and because some of it is more expensive it puts a higher floor price under oil. However, it does mitigate the increase in oil price.

    The overall effect of this is that even though oil production is declining, any rise in price caused by that decline will act to increase supply and reduce demand. Even though this may not happen much in the short term, nor will oil supply decline much in the short term (or rise – oil production facilities take a long time to turn on or off). So whilst I agree with you that oil prices will go up this year on short-term supply and demand, I think you are very mistaken to cite Peak Oil as a reason.

    LM

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  8. LM: Consider other countries that are not in a position to buy electric cars (they still drive old ones made last century), big transport like buses, freight trucks, all powered boats, all aircraft, heavy machinery like earth moving equipment. So many things actually ‘require’ fossil fuels without alternatives.

    None of these can run on batteries, gas (mostly), uranium, solar power. The problem we really have is that we are so addicted to fossil fuels that we will not be easily weaned. The sheer convenience, portability and energy output (per weight) of the fossil fuel combustion engine makes it essential for those services I mentioned above.

    And as for Uranium…Problems such as: sheer scale (try put a uranium engine in your car), finite resources, unattainable resources (depending on which country you are in), political issues, price is not really competitive (yet).

    One portable alternative fuel is hydrogen, which is crazily energy expensive to produce and dangerous, methanol which is an option, ethanol (lets not revisit the biofuels saga). I can’t think of others right now.

    We all know what human nature is like…we leave everything until it is too late. Climate change, financial reform, infrastructure investment – we (governments!) always leave these things until there are huge problems before we start investing in a fix. I think our ‘peak oil’ problems will well and truly be an issue before anything significant is done about them.

    That said, I do agree with you in part that (and Dan has mentioned this before) demand will subside and innovative new technologies will arise from increased fuel costs to ‘partly’ mitigate the reduction in supply. However I think that in the coming decades we will see a less energy convenient world with an unfortunately less prosperous way of life.
    Perhaps we will migrate to the online world instead of international travel, grow our own food, become techno-hippies, etc.

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  9. You do not take into account that oil is being supplemented by biofuels. As the technology to synthesize oil advances, drilled oil is going to account for less and less of the supply, and the price of ‘oil’ will follow the price of maize and suger – which follows the rainfall patterns.

    Your articles are too short, Dan.
    You could add a bit more detail.

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  10. I think Peak Demand theory makes more sense of Peak Oil. From what I recall $60 a barrel oil is the figure many oil analysts reckon is a reasonable value so it seems likely that at some point when demand picks up, oil will creep back up to that range. Anyway the best and most insightful discussion about what drives oil prices etc I have found is on the Gavekal discussion forum. It is well worth reading. (Google “Gavekal Peak Demand”)

    Reply

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