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Stoneleigh,
Great job covering the credit situation. You were one of the few people who had this pegged over a year ago.
Are you surprised oil is still at $77 at this point?
SAT,
Given your impressive performance in the 2006 oil price prediction stakes, what are our predictions for the future?
Peter.
BP,
I'm looking at three factors that could have a profound impact on oil prices over the course of the next three years:
1) The developments in the credit market that Stoneleigh has done such a great job covering here at TOD Canada. Obviously, if the credit situation leads to a slowdown in U.S. consumer spending, this will be very bearish for oil prices. On this front, I think a U.S. slowdown is already baked into the currency pie, so any contagion to other economies would result in a strengthening dollar, which would be even more bearish for oil and commodities prices.
2) I believe that the U.S. Current Account Deficit bubble is unsustainable and, therefore, will eventually pop. This can only come about through a collapse in the value of the U.S. dollar. I find myself wondering, with the Current Account Deficit now approaching 1 trillion dollars, where China/Japan/GCC will find that amount of secure U.S. dollar-denominated investment vehicles in which to invest their surpluses. If situation number 1 continues or worsens, I have a hard time imagining they will be investing much in the financial/household/corporate sector. That leaves the government sector, but the U.S. deficit isn't anywhere near 1 trillion at this point. So at some point, they may be forced to start selling their dollars either for some other currency (Euros?), their own currency, or gold. A collapsing dollar would obviously cause oil prices (and everything else) to skyrocket in dollar terms.
3) The third factor is peak oil/ELM. If oil production really has peaked, and if the Westexas Export Land Model plays out the way it seems like it will, oil prices could conceivably head higher even in the face of a credit-induced recession.
So, i'm not making any predictions at this point, just watching these three factors and reacting to how they play out. If this credit crunch worsens and sends the economy into a severe recession, that will be the event of the decade. If the Current Account corrects, that will be the event of the century. And if oil production has peaked, that will be the event of the...what?
SAT,
I've enjoyed yours and Stoneleigh's thoughts on these financial matters, their implications, and which tea leaves to watch.
I do have a question tho. In your #2 scenario above, you talk about the "US Current Account Deficit now approaching 1 trillion dollars" and then seem to contradict yourself by saying "but the U.S. deficit isn't anywhere near 1 trillion at this point."
Forgive me my economic stupidity here but could you better explain what you mean, which I'm assuming has to do with slightly (or is it vastly?) different US deficits. A brief explanation would help undo my befuddlement. Thanks.
Godraz,
The Current Account Deficit is basically the trade deficit. The U.S. Current Account Deficit is approaching 1 trillion per year. What this means is that the surplus countries (mostly China, Japan, and the gulf states of the Middle East) end up with one trillion U.S. dollars which they must reinvest in dollar denominated assets if they don't want their own currencies to appreciate. The last thing these countries want is for their own currencies to appreciate. So they send these dollars back to the U.S. by investing in U.S. corporate debt, government debt, agency debt (Fannie May and Freddie Mac), or corporate equities. The problem right now is that corporate equities and debt are becoming far less attractive, and agency debt and other mortgage related debt will be issued more and more sparingly as the housing bubble corrects. That leaves government debt (the budget deficit), which is only around 200 billion per year. What I was referring to in situation 2 is that there may come a time when there simply isn't enough secure, money-making, U.S. denominated assets for the surplus countries to invest their dollars in. At that point they would have no choice but to convert their dollars into their own currencies (the option of last resort from China/Japan's point of view), convert their dollars into other currencies (for example, they could convert their dollars to euros and then buy euro-denominated debt), or buy something else like gold. We aren't there yet. The federal government is only issuing 200 billion or so of new debt this year, but the surplus countries can still enter the market and buy existing debt from other parties. The expected result of this would be to drive down bond yields. Watch the ten-year bond yield, for example. It's already down to 4.74% from above 5% a couple of weeks ago. That drop from 5% to 4.74% might not have anything to do with the Current Account situation described above, it is more likely just the result of people expecting economic conditions to worsen going forward (which also tends to cause yields to fall). But if at some point you see that yield really starting to tank, then the economy starting to pick up (since mortgage rates are tied to the yield on the ten-year bond), inflation picking up, asset prices spiking back up again, the fed raising interest rates to try to deal with inflation, and then the ten-year bond yield continuing to fall even in the face of Fed tightening, you will know it is because the surplus countries are buying up huge quantities of existing debt. The bottom line is that if the Current Account Deficit is 1 trillion, the surplus countries must find 1 trillion worth of U.S. dollar denominated debt to purchase. If they can't, they will be forced to begin purchasing something else, and this will lead to a dollar collapse.
Thanks SAT.
Ok, the distinction I was unclear about in your post had to do with the annual US Budget deficit (200+ M) vs. the accumulated Trade deficit (~1 T).
(Of course, there's the $8.9 trillion public debt, and the $50+ trillion and growing in total US govt. (We The People's govt.) liabilities of debt (according to the GAO). All this debt makes my head spin.)
I do understand the biggest trade surplus holders (China/Japan/GCC) have been sopping up US debt instruments, which seems counterproductive to me, seeing as they get paid back with more US $; although I guess it has kept us afloat to keep buying their stuff (so everyone can buy the GCC stuff); all of which just adds to their growing surpluses. Seems like a vicious cycle which works fine until it doesn't -- like beginning now with the unraveling of debts in the housing market, putting the squeeze on the consumer and within the credit lending mrkts. debt instruments, etc.
But why this US recession would strengthen the US $ I don't get. A US recession suggests lower US interest rates, which should hurt the $ strength relative to other currencies. And any $ strengthening interest rate hikes wouldn't help in a recession. Although in a contagious recession they'd lower their rates too. Japan doesn't have much room to go any lower. That leaves the Euro (primarily, although there are others but none that compares overall).
Obviously I'm missing something here. Although I do understand it's a fine mess we all are in. One that is loaded with trap doors everywhere one looks for relief, which is why I've got eggs stashed in every conceivable basket. Hopefully, one of them will survive the gut wrenching slow motion smash-up. Can't we just fast forward this thing and be done with it already! If I'm going to get screwed financially I'd prefer it was done with quick so I can rest up for the next one in line.
What a way to go.
Hi SAT,
Other than doing a bit of stock market trading, of the head in a sack variety, financial things are a mystery to me. I do not understand why China selling selling goods to the US is not taking those dollars and plunking them into goods, for instance, like oil and grain. Or are they doing that and just have so much more cash in hand that they need to buy 'American debt',( which I take to be all forms of bonds and treasury bits and pieces)? If so then that 'need to buy' would slide into the Canadian end of things equally? I guess that would mean that what my broker, and I guess every other broker in Christendom, keeps talking about bonds being a hedge against stock market slumps would not be in the end that simple sanctum sanctorum of monetary peace and safety?
BTW,Stoneleigh, Thanks for your comment on my plan, I didn't think it much of a plan either. I liked Jenks logical way of looking at it as well. Gotta take care a bit of these days or we all going to end up living with Baldrick in his drainpipe.
I expected oil to start dropping just because of selling to cover margin calls.
Of course this could be balanced by a move to commodities as a sort of flight to safety.
At the moment so much money is moving around the world that you probably can't see and real moves based even remotely on fundamentals.
Thanks SAT :) My first TOD post in October 2005 was about deflation, and I've been at it ever since. The writing has been on the wall for a long time. Liquidity can dry up incredibly quickly as a credit bubble implodes.
I'm not surprised about oil at $77 for now, but I think it's probably peaked. If it was still $77, let alone higher in a month or two, I'd be very surprised indeed. I agree with what Nate said over the weekend - that $50 oil is almost a mathematical certainty. In fact, if I were a betting person, I'd bet on lower than that.
As I've said before though, a lower nominal price doesn't necessarily translate into greater affordability, depending on what's happening to the money supply. Purchsing power could easily be falling faster than price.
Stoneleigh,
When deflation follows a credit boom, it is usually due to the fact that demand doesn't keep up with production capacity. In the near future, we may see this in such areas as office space in Dubai, many Chinese industries (which export to the entire world), but is it true of the oil industry? Even with the enormous amounts of liquidity and credit that have washed over the world economy in recent years, oil production is currently stagnant. Chinese industrial production has been growing 20% a year for a decade, there are almost as many cranes in Dubai as people, but oil production is stagnant. I'm not saying oil prices still can't fall if this gets ugly, but it won't be because the credit boom has led to a large increase in production capacity. Do you think we should expect this credit bust to have more of an impact on the prices of homes, commercial property, cars, t-shirts than on the price of oil?
Thanks for your reply.
Can I just clarify something, in your first factor, you say that if the credit crunch leads to a slow-down in the US economy then oil will tend to go lower.
But in your reply to Stoneleigh about deflation following a credit crunch, you seem to resist the idea of a fall in oil prices.
So, I'm guessing that there is some complexity within the term "credit crunch" which can lead to different outcomes. Can you (or Stoneleigh, or anyone) elaborate on this?
Cheers,
Peter.
BP,
A, "credit crunch," in the absence of 2 and 3, would obviously send oil prices much lower. Factor 2 is not present at the moment. In my question to Stoneleigh, I was alluding to the role factor 3 may have played in the, "credit boom," which now seems to be ending. Why have the massive amounts of easy credit available during the last few years not lead to an increase in oil production as would normally be the case?
Sorry about the delay in replying, but I've been away from my computer for a day or so.
My view of the future for oil prices is that a sharp downward spike due to deflation (which should occur in most asset classes across the board), would probably be followed by a rebound to new all time highs, although I don't have a clear idea about the time frame. I would definitely expect international contagion, which I agree with you would tend to push the dollar higher temporarily. In fact I think we may see a short squeeze in the dollar that could lead to a substantial spike, but I don't think that would last long. Eventually the dollar will go the way of all fiat currencies.
I would say there are strong competing forces driving oil prices in different dierections, the outcome of which is likely to be high price volatility, potentially for quite a while. Deflation drives prices down, partially due to the effect of activity in the financial markets swamping the energy markets, and partly because demand presupposes purchasing power and a strong contraction of the money supply could cut purchasing power very substantially. However, with oil production peaking and many geopolitical risks on the verge of being realized, there is likely to be strong upward pressure on price, especially if the realization of geopolitical risk involves a significant impact on supply (ie sabotage, terrorism, piracy, civil war in oil producing regions, a global resource grab etc).
I think deflation will dominate initially, but probably not for long (at least relation to oil). My guess is that a global resource grab is likely to result in oil supplies being tied up in bilateral contracts, and hence the demise of a global oil market. If, in the (potentially violent) process of securing supplies, oil production or delivery infrastructure suffers substantial damage (I would expect this to happen), then supply could fall very quickly. Supply, and therefore price, could then vary enormously both between regions and over time. That kind of extreme risk would tend to remove private capital from the game, so I would expect national oil companies to play a much larger role in the future.
The one thing we can count on I think is an exceptional degree of disruption. Business as usual simply can't happen, because all the assumptions it is built on are about to be abruptly invalidated IMO.