deflationary

Oil Over But The Shoutin’ : The Endgame In Oil

Sanjeev

Sanjeev

To recap, in the perspectives I have put out in the last 2 articles, I made the following big points:
  • That we are living in a deflationary world, mostly. If we are blessed with disinflation in India, it still helps to put on a deflationary filter to perceive the world. For example, it would be a good idea to put yourself in the shoes of a boy who turned 20 in Japan, in 1989. He would be in his 47th year now, having lived 27 (57%) of his 47 years in deflation.
  • That QE is (ultimately) deflationary, although markets initially react to it as if it were inflationary. That is because the conditions under which QE is announced are deflationary/ depressionary, and the act (QE) does not change the trend (deflation).
  • If we use the ‘word count’ in world media for Deflation, then enough people quite clearly think it will happen, and as we know with financial markets, if enough people think it will happen, it will…
  • China’s manufacturing investment quite clearly has been a bubble, and it looks like some 30-40% of the Gross Fixed Capital Formation has to be closed down and the related debt is written off. That would amount to some 40% of Bank assets being stressed, of which half is to be written off, the equivalent number in India being 12% and 6%. SOE output is down to 26% of GDP, while they accounted for 80% of the debt accumulated in 2008-10.
  • Europe and Japan are in QE, while the US seems to be in a hardening cycle, even if in a stop-go fashion. The BRICS, bar India, have all suffered because of the commodity bust and have problems of the China kind, perhaps smaller. They will all see anemic growth with mini-banking crises.

Declaimer: This article was originally in February 2016, and some of the data points may be outdated

The biggest commodity in the world

The biggest commodity in the world is oil. In a $ 62 trn economy (2009), energy used to be nearly 20%, i.e. $ 12 trn. This year, the energy industry is about half that size in a $ 80 trn economy. You can imagine the deflationary impact of oil on the nominal economy. Some $ 380 bn of private investment is being called off in just the shale economy of the US.

If we count a $70 structural drop in the price of oil, it means that world oil reserves of 1.6 trn barrels have seen a wealth erosion of nearly $100 trn. This is not counting the wealth of the other dominos in the metals and mining industries. Remember, corporate profits are 4-6% of GDP in most countries, so it will be about 25 years before the world recovers this wealth in nominal terms. In terms of its impact on human behavior, the people who have lost this money will never be able to retrieve it in their lifetimes.

So the Arab oil sheiks, the Russian oligarchs, the Brazilian sugar barons, and the Australian mine owners, will never see their wealth go back to the nominal levels of 2008, ever again.

To understand what happened, you have to think about past oil prices as a ‘wedding cake’. At the base was the cost of finding the oil: the geology, the fact that oil was generally found in the most inhospitable and inaccessible places in the world. And the fact that you had to find “lakes of oil”, small puddles of oil would not do.

This contributed, say, $10 per barrel, which quickly went down to zero, as the previously inhospitable region (Saudi Arabia, Texas, Alaska, Kazakhstan, Siberia, etc) became a part of the mainstream world. Also, equally inhospitable areas in the Bakken, US were accessed by tractors carrying (shale) oil drills.

Then came the Capital Cost of extracting the oil, and transporting it. This was a job with enormous capital barriers to entry, open to only the largest firms in the world and State players. Let’s say this contributed another, say, $20 per barrel. Over time, even this started to halve, as Interest Rates fell.

Then came the “Cartel Costs”, the cost of having an artificial monopoly like OPEC dominate the oil market. This we know from hindsight now, cost about $60. Then the fear premium that came from the geopolitics of the Brat Pack of Middle Eastern countries would contribute to volatility in the Forward markets in oil. Lastly, the fact that it was the biggest physical commodity in the world, and therefore, both impacted and impacted by the Dollar and other money flows. It almost became a pseudo-currency on par with gold. While there are only 183,600 tonnes of physical gold in the world valued at ~$7.8 trn, the value of oil Reserves (which can be mortgaged and the expected cashflows hypothecated) was over $150 trn. Remember, M1, the narrow measure of Money Supply, is just $30 trn in a world economy of $ 80 trn. Broad money, M3 is $80 trn, and stockmarket capitalization, just to give you a sense of perspective, is $ 70 trn.

the wealth effect

In a world like this, just the CHANGE in the oil market is about $ 100 trn, while total world debt is about $ 200 trn. Through a combination of the “wealth effect” and the direct loss of income, this will contribute to asset-price deflation as well as the very visible product-price deflation that we are already seeing.

But asset price deflation slows down the Velocity of Money through the “wealth effect”, which further pushes asset markets into a deflationary death spiral.

The oil market therefore affects the ‘potential growth rate’ of major resource economies, and its decline will structurally shift the (economic) potential of the said economy. The entire Middle East, Venezuela, Russia, and perhaps Nigeria, even Canada and Australia will fall into this class. Some of these economies will never come back to the same relevance in the world economy that they enjoyed earlier. Some others, India in particular, will see relative improvements, but it won’t feel good in a deflationary world…..that is the nature of the beast.

The size of the physical commodity market

While the size of the physical commodity market may not shrink, the economic value of the goods so exchanged will shrink dramatically. This will reduce the Velocity of Money, and since the human mind thinks in nominal terms, this will feel like a recession, creating a deflationary spiral.

Spinoff effects will also happen. Prominent users of oil, downstream petrochemicals, mineral-based manufacturing, and the logistics industries will see sharp drops in input costs, but a resulting drop in prices will not lead to a concomitant increase in volumes. The recent drop in the Baltic Freight Index from 869 to 310, is not driven so much by sluggish demand for merchandise freight, as by the drop in input prices, mainly fuel oil.

So far, we have discussed only the direct effects on oil as an industry, its pricing dynamics, and its asset valuations, then the knock-on effect on money/currency/commodity markets, then the Velocity of Money and spinoff effects on downstream and user industries. The wider impact on the economy will transmit itself through the deflationary spiral: one, all leveraged assets (especially companies) will face the pressure of Deflation, as the real value of their debt increases even as their pricing power and earnings diminish. We are seeing this spectacularly in the steel and power industries in India, as debt contracted at 7 years’ cashflow (or 4-5 years’ EBIDTA) and has grown to 20 years’ cashflow (and 15 years’ EBIDTA) as margins have been decimated even before the commissioning of the project.

The ultimate leveraged asset is Real Estate, which is 85% financed by debt at the margin, and whose sustainable valuation is about 7 years’ Income. The same thing has happened on a much wider scale, resulting in a halving of the prices in highly leveraged markets (like Delhi) which have a big inventory overhang. Most people don’t trace this to the oil market; I am merely making the point that if oil started the deflationary avalanche, and it accelerated through knock-on and spinoff effects, finally reducing the Velocity of Money, then it is the perfect storm, the final domino being Real Estate. This will bring the deflationary alligator into your house; if you are doubly unfortunate to have also lost your job in one of the CDR cases, then that is just your luck.

But if you are still alive, the only way out is to find a successful, solvent 47-year-old Japanese and ask them what they did to survive. I am told that Akie Abe, the wife of the Japanese Prime Minister, Shinzo Abe is 53 years….but marrying our Prime Minister seems to be ruled out as a deflation-survival option!!!

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