Oil Price Crash

If there’s one resource that makes the modern world go round it’s oil. Pick a major financial crisis or military conflict of the past 60 years and there’s a pretty good chance oil was involved in it somewhere. It’s not just the fuel that drives our cars, trucks, ships, airplanes and a lot of our power stations; it’s also an essential raw material for the plastics and chemical industries. When oil supplies are threatened we see panic buying of fuel, rocketing prices, sometimes even public disorder. Even routine cuts or caps on OPEC output can have a dramatic effect, pushing prices up and placing a brake on the whole economy as everything costs more to power, manufacture and transport. A large part of the USA’s foreign policy since 1945 has been aimed at ensuring a reliable, affordable supply of oil.

But what happens when the usual oil shocks are reversed? What if the market is glutted with cheap oil as supply outstrips demand? Right now we’re finding out. In June a barrel of standard crude cost over $100. The lighter, sweeter Brent and West Texas Intermediate – both in high demand for making gasoline, kerosene and diesel – were selling for more than $125. That was good news for the economies of the Middle East and Russia, the axis of the world energy market. But it also opened up options for the USA. New domestic oil sources like shale have a higher extraction cost than traditional drilling, but at $100 a barrel it was still profitable to extract it. That helped power the boom in production that’s made the USA almost independent of foreign oil for the first time in decades.

Then, in late summer and fall, it started to change. The increase in supply had a downward pressure on prices anyway but not enough to cause any real difficulties. Then a deliberate fall was arranged to hurt the Russian economy; Putin’s budget plans depended on prices of at least $100 a barrel and the break-even point is around $80. With the price dropping through that price in early November Russia has now been losing money for six weeks and struggling since late summer. The idea was to punish Russia for invading Ukraine, but it has potential to backfire.

Usually when oil gets cheap OPEC restricts supply to drive the price back up again. This time they haven’t. Obviously that helps keep Russia poor but the Saudis and their Emirati allies look like they’re aiming more at the USA. The growth of shale oil has threatened their profits, with US demand for imports slumping and the still-recovering economies of Europe and Asia not ready to take up the slack. Now, with prices already low, the Saudis are taking a shot at restoring the balance. Shale oil, with its higher extraction cost, is more vulnerable than Gulf crude; by holding supply up, and prices down, they’re hoping to run the US industry at a loss for long enough that production falls. If they can do that OPEC will regain some of their lost bargaining power – and right now, with the situation in the Middle East, that’s not a good thing.

Ironically, while Russia’s definitely struggling and their economy has shrunk by around 8 percent, they might be better placed to survive. Their actual production costs are among the world’s lowest and that gives them a bit more slack. US shale runs on much smaller margins though, and it’s already making a loss. Higher oil prices bump up costs right across the economy, but right now that might be a price worth paying to ensure energy independence. But with the Saudis now saying they’re prepared to let it fall to $20 a barrel it could be a while before we manage that.

New Debt Danger

Earlier this year it looked as if we’d got past the worst of the 2008 debt crisis, but recently fears have been rising again. The main driver has been the issues in the Eurozone, where a version of quantitative easing is being hotly debated. In favor are the president of the European Central Bank and the struggling Mediterranean and Francophone economies; Germany, who would end up paying most of the cost, is opposed. With even the German economy slowing down there’s a strong possibility of renewed debt issues on the continent – but now there’s another issue that could be even worse.
Right now the world’s economic miracle is China. From a mostly agricultural society in the 1960s it’s grown to be a top-rank manufacturer and is steadily diversifying from high volume cheap goods into higher quality products. Growth has been explosive, but now it’s slowing down. And that has implications for the huge industrial sector’s ability to repay its loans.
The scale of loans to growing Chinese companies is immense and rising rapidly; the Swiss-based Bank for International Settlements, the global lending watchdog, says dollar-denominated credit is rising at 47 percent per year. What’s really worrying analysts is that much of the lending in China is camouflaged as inter-department financing within companies. This has been done before, in 1920s Germany, and the reason then was to disguise the state of their balance sheets as the 1929 crash approached. The concern is that a lot of Chinese firms are much more exposed than they’re letting on, and if an economy that size starts to unravel the impact on global markets will be catastrophic.
Now, on top of these worries, the Federal Reserve is starting to tighten up the easy credit that’s been fueling the US recovery. With this year’s growth and jobs figures looking pretty healthy the Fed is winding down its quantitative easing program, and while it’s justified in domestic terms it runs the risk of a credit shock abroad. China and the other East Asian economies are most at risk there but there are also immense dollar loans to other emerging economies – Brazil and Mexico have borrowed eleven-figure sums and Russia’s debts exceed $700 billion. In total cross-border lending in dollars has tripled since 2005 with the full figure now estimated at $9 trillion, mostly outside the US regulatory sphere.
What’s worrying observers is that for the bulk of this debt there’s no lender of last resort. China’s central bank could manage a bailout – it has huge reserves of greenbacks – but the other borrowers probably couldn’t. A crash in any one of them could start a chain reaction through the whole offshore dollar market.
Fund managers are talking up their prospects right now, but the markets are volatile. The BIS believes there’s an underestimated level of fragility beneath the optimistic picture and many of the conditions for a new crisis are already in place. Leveraged loans exceed what they were before the crash at an unprecedented 55 percent of all collateralized debt obligations. Meanwhile the dollar is rising strongly against most other major currencies.
If there are dangers hidden in the current situation there are opportunities too. Commodities are at a bargain price right now but will probably rise in the event of a slowdown. It’s definitely a good time to be making plans for a potential crisis.

China Rate Cut

Despite continued doubts about underlying employment figures the US economy is looking fairly healthy at the moment and seems to be recovering from the financial crisis, but many analysts are worried by the situation in Europe. With disappointing growth figures from all the major Eurozone nations there’s anxiety about what that could mean for Euro stocks, and the potential for a knock-on effect on the USA. However developments on Friday helped ease fears for the moment, and may have bought the Eurozone some more time to resolve its issues.
The main news was an unexpected interest rate cut by the Chinese central bank. This move, announced before markets opened Friday, took most analysts by surprise but makes perfect sense in the circumstances. While the Chinese economy is one of the most spectacular examples of growth over the past few years there have been recent signs that this might be slowing, and easier access to money should help stimulate it. The cut takes the central bank’s deposit rate 0.4 percent to 5.6 percent. As well as making credit easier for startups it should also encourage investors to opt for equities over bank deposits. The new rates kicked in Saturday morning, so the markets will be watching carefully to see where equities go over the coming weeks.
The other welcome news was a speech by European Central Bank president Mario Draghi, delivered to German economists in Frankfurt. Draghi signaled that the ECB, which has been cautious this year, is moving towards implementing a new round of full-on quantitative easing to inject some life into the continent’s sclerotic economies and raise inflation to meet planned levels. The UK has managed to stimulate growth by reducing spending and tax takes, but the Eurozone has been less successful; the revelation that Draghi is considering a more interventionist line boosted optimism and pushed all the main stock markets up sharply. London’s FTSE 100 saw a 2.3 percent rise over the week, and 1.3 percent of that came on Friday afternoon. France’s CAC and the German DAX also saw rises of over 2 percent as traders bought in to the promise of higher profits and corporate growth.
Europe has been struggling this year, against a toxic cocktail of low growth and low inflation. Even Germany, long regarded as the powerhouse of the continent, seems to have run out of steam of late. The situation in France is far worse, and the Mediterranean fringe is still reeling from the disaster of the debt crisis. Anything that helps rebuild confidence among businesses and investors is very welcome news, and with the EU being one of the USA’s largest markets it’s good news for US businesses too. A renewed recession in Europe is going to hurt demand for American products and services, which would drive down share prices on the New York exchanges. Hopefully by adopting quantitative easing, even as the Federal Reserve is backing away from the policy following recent announcements, that danger will be averted long enough for the Eurozone to turn the corner.

Black Friday 2014

It’s now less than two weeks to Thanksgiving and, right after that, Black Friday. With the current lack of confidence in the economic recovery many financial commentators and most of the media are starting to build up speculation about the annual retail frenzy, usually through making the claim that it’s a bellwether of how the critical holiday shopping season will turn out. Good seasonal sales figures will offer a significant boost to many US businesses, and in turn that will affect share prices and help shape the market as a whole for next year.
The big question is, how much does Black Friday actually mean for pre-Christmas retail spending? The conventional wisdom is that it’s a key measure, and higher spending on that day means good figures can be expected when it’s all tallied up in early January. Many analysts think that idea is media-created hype though. It’s hard to find any correlation between Black Friday sales figures and performance for the season as a whole, because the data points are widely scattered. To the extent any association can be drawn it’s pretty weak – and it suggests that a better Black Friday tends to mean a worse retail season.
The reasons for the rise of Black Friday itself are simple. Unofficially it’s the start of the Christmas season, and for many employees it’s also a holiday. That means a lot of people are going to grab the chance to get an early start in the annual gift-buying extravaganza. Over the decades – it seems to have been a significant shopping day since at least 1961 – it’s built up momentum as stores compete with each other to be the one customers line up in front of. However looked at rationally there’s no reason to expect that one day to make a real difference to the entire season.
The fact is that most people have a pretty fixed budget for Christmas shopping, and whether they spend it the last weekend in November or the last weekend before Christmas doesn’t matter much. In reality it’s not quite that simple. Lower prices and a fixed budget could mean more gifts being bought, and while that won’t affect retailers’ profits much (and any influence is likely to be a negative one) it could help the companies who make those gifts. These effects probably balance out though. Overall, people are going to spend what they planned to spend.
There’s also a possible – and rational – explanation for that weak link between a good Black Friday and a bad December. Lining up for post-Thanksgiving bargains takes some effort, and people might be more willing to make that effort if they’re feeling financial pressure and want to stretch a smaller budget as far as possible. In other words strong sales at bargain prices could indicate that consumers want to spend less overall.
Black Friday is now a regular fixture of American culture, and since 2005 it’s had the highest single-day retail takings every year, but despite the media hype and popular belief it doesn’t really say anything useful about sales figures for the rest of the year. It can affect investor confidence but that’s just the fickleness of the market at work.

Gold Since 2011

Over the past few weeks metals investors have been watching gold fall to levels it hasn’t touched in four years. There are signs that this long decline might be ending, leaving an opening for smart buyers to get in at a bargain price, but what can we expect in the future? Is past performance a reliable enough guide?

Looking back over the last five years, what really stands out is the heights gold reached in the late summer of 2011. Following the 2008 financial crisis many investors moved money to gold as share prices plummeted. It didn’t take long for the Dow to start regaining the lost ground – by the middle of 2009 it was back on an upward trajectory – but the recovery wasn’t robust and there were frequent dips. With all the major economies struggling to pull themselves out of recession the markets were painfully aware prices could fall back at any time, so a safe haven like gold saw strong demand. By mid-September 2011 it was trading at $1,860 per ounce and looked set to keep going to the $2,000 mark. Then, on September 23, it abruptly fell by more than $100 in a single day.

The usual reason for a sharp fall in gold – a jump in stocks – doesn’t apply here. In fact the Dow had lost nearly 500 points the day before and was showing no sign of recovery. Many analysts blame gold’s losses on the CME Group raising margin requirements by 21 percent; the previous time they did this it triggered a similar drop in gold prices. Whatever the cause there was a strong adjustment downwards, with gold falling to $1,600 by the beginning of October. It then rallied and made its way back to $1,800 by the end of that month, and fluctuated between $1,500 and $1,800 until October 2012. That’s when it started the downward trend that, hopefully, is bottoming out right now.

That trend hasn’t been an even one; there have been several points when it looked like reversing . Most of the drop happened between October 2012 and June 2013, when the spot price touched the $1,200 barrier for the first time since 2010. Then it climbed back to $1,400, dropped all the way back again by the start of this year and started climbing once more. It reached its 2014 high of $1,382 in late February and it’s been mostly downhill from there.

Overall the decline of gold can be linked to the recovery in the equities markets. Both the Dow and the FTSE 100 have been ratcheting up since 2009, and inevitably that’s going to slowly rebuild confidence in stocks. Because lack of that confidence is what drives investors to gold in the first place, as it returns they’re going to sell metals and make their way back to shares. However what we might be seeing now is the pendulum starting to swing back; the rise of equities has stumbled a couple of times recently and while the main indexes haven’t lost any ground it doesn’t look safe to assume they’re going to keep rising in the short to medium term. Gold price charts for the last two weeks seem to show more interest in a reliable hedge against a bear market, so while we don’t think gold will be back above $1,800 any time soon a return to $1,400 is a different story.

Financial Update 9-22

The US dollar has been having a good few weeks. After months of lackluster performance it now seems to have broken out and headed for the high ground, registering significant gains against all the major benchmark currencies. That’s attracting a lot of attention to the Forex market right now as opportunities appear there, but it also has effects in other areas and one commodity that’s been feeling the chill recently is gold.

dollar-vs-goldDecent second quarter figures for the US economy have given the dollar a nudge upwards but it really took off when the Japanese government moved towards a more generous quantitative easing strategy and the European Central Bank started making noises about going in the same direction. That raised the specter of inflation in both those economies, prompting investors to shift away from the risk of weakening currencies. At the same time the UK pound has been struck by worries about the possible consequences of Scottish independence, which were only resolved by the No vote at last Thursday’s referendum on the issue. With the dollar already looking healthy it was the logical place to go for anyone who wanted to keep their money in currency.

At the same time a recovery in the equities market was having an effect on the values of precious metals, a traditional safe haven any time stocks are looking weak. When stocks go down metals tend to rise, and vice versa. With the Dow and FTSE 100 showing some of the best growth since the financial crisis hit gold and silver were already heading south, so when money that had been tied up in Euros and Yen started looking for a place to go metals weren’t looking attractive. The dollar, already rising because of the economy’s apparent health, was. It made sense to get behind it, and that was enough to accelerate its climb. In fact its performance has been incredible recently – last week’s 1.2 percent jump in the Dow Jones FXCM dollar index was the largest in 10 months.

So how long will the resurgent dollar continue forcing gold down? It’s hard to say. In theory metals should stay depressed as long as the dollar remains strong; the basic circumstances that caused the swing won’t have changed. In practice it’s almost never as tidy as that. For US investors gold isn’t looking very attractive just now, but the same picture doesn’t necessarily hold globally. Anyone in Japan or the Eurozone faced with the prospect of a weakening currency could still profit on gold even if its dollar value remains low; as long as the gap between the Euro or Yen keeps widening faster than gold’s dollar price sinks they can invest in metals and make a profit in their own currency. If enough people start doing that then gold will inevitably start to rise again, making it even more attractive and pulling in more investments. Eventually it could reach a point where it’s bullish enough that people sell dollars to buy gold.

The interplay between stocks, currencies and commodities is always complex and sometimes just incomprehensible. The best we can do a lot of the time is look at what’s happened before. One clue to watch for is the Fed’s policy towards the money supply. Gold often tracks that closely, so stay tuned for any update on interest rate policy. In the meantime don’t ignore the potential of gold – it often generates unexpected profits.