Global markets are in meltdown mode, and a collapse in oil
prices is the fuel to the fire sale. Stock
prices began the New Year falling by 10% in the first two weeks alone. After feeble attempts to recover ground, the
deluge of bad news from the energy sector has investors questioning the
viability of the Wall Street banks that fueled the shale oil boom with lavish
loans. We are near a level of fear and
loathing that swept through the markets when Lehman brothers collapsed in 2008.
It doesn’t seem that long ago when oil was $145 a barrel and
Wall Street energy analysts were falling over themselves claiming that Chinese demand
and Peak Oil spelled the end of the “cheap
oil era,” and prices would be higher for the foreseeable future. How times have changed. The price of oil is below $30 and heading
lower. At the recent annual
International Petroleum Week conference in London, industry members pondered
the possibility that oil prices could stay low for the next decade. What happened? In a word, financialization of commodity markets. First, deregulation in 2000 allowed financial
interests to take over commodity markets and turned oil (and all
exchange-traded commodities) into an asset; second, as an asset, oil prices experienced
a series of bubbles from 2003 to 2011, creating a belief that higher prices were
permanent; third, expectations of higher prices fueled a debt-financed
investment boom in shale oil production; finally, the inevitable bursting of
the bubble sparked a debt-deflation process which could lead to another global
financial crisis.
I detailed the forces underlying the financialization
process in commodity markets in an April 2011 piece
here. To summarize, since 1980, profit-seeking Wall
Street banks have been trying to break down the regulatory barriers put in
place during the 1930s. In the case of
commodities, they created Commodity Index Funds (CIF) and Exchange Trade Funds
(ETF), investment products which allowed them to circumvent regulations
restricting their activities. Once the
new products were accepted, they then pushed to formally deregulate markets,
which was done through the Commodity Modernization Futures Act of 2000. In 2004, a research paper by two Yale
academics (and funded by AIG) showed the return from holding commodities in a
portfolio was negatively correlated to stocks and bonds. Adding an asset whose return rises as stock
prices fall stabilizes the portfolio’s returns, and this is a characteristic
prized by institutional investors like pensions, insurance companies, and
endowment funds. By 2006, the markets literally
flipped, as financial traders went from 20-30% of market activity to
70-80%. Commodities became an asset
choice for investors, and asset prices are more volatile and subject to bubbles
by the herd behavior of said investors. Financialization
of commodity markets, then, set the stage for a series of price bubbles that
created a belief that $100+ oil was here to stay.
Certainly, the Chinese growth story was real, and it provided
the foundation for steadily rising prices, but oil and other commodity prices
were pushed beyond supply and demand fundamentals by investors, with Wall
Street banks acting as cheerleaders. Historically,
price movements of these magnitudes were the result of severe supply
disruptions: for example, the OPEC oil embargoes of 1974 and 1979, and the
first Iraq war in 1990. While there is a
contentious (academic) debate regarding the extent to which investors can influence
oil prices, in 2011 even analysts at Goldman Sachs (ironically) suggested that
speculators were adding a 20% premium to the price of oil.
The first commodity bubble rode the back of the Chinese
growth story, but it was also instigated by the research on commodity
returns. Pension funds, insurance
companies, and endowments plowed in. From
2003 to 2006, CIF investments doubled from $80 billion to $160 billion, and the
price of oil doubled from September 2003 to September 2006 (from $37 to $74). Complaints from commercial market participants
led the US Senate to investigate speculative activity in the oil and gas markets,
and a report was published in June 2006 which concluded that unregulated
speculative activity in electronic commodity markets was spilling over and
influencing prices in the regulated exchanges.
Even though China was in the middle of several years of double-digit economic
growth in 2006, this first oil bubble popped in the last quarter of 2006, with prices
falling by 27%.
Not coincidentally, the second bubble began just as the
housing bubble started to unravel. Oil
was a little over $70/barrel in July 2007, and it would go on a spectacular run
over the next year, peaking at $145 in July 2008. Energy analysts at Wall Street banks were falling
over each other to see who could predict a higher price, of course blaming
relentless demand from China, even though the Chinese economy slowed
considerably in 2008. The reality was
Wall Street touts had encouraged another $120 billion dollars (bringing the
total to over $300 billion) of investment money into CIFs during this period.
At the time, some analysts also blamed stagnant supply, and
indeed OPEC production did not increase during this period; however, OPEC’s
production decision was a consequence of learning from the previous bubble. From 2003 to 2006, OPEC producers responded to
the China demand story by increasing production by some 4 million barrels per
day, only to find prices collapse in late 2006.
As prices spiked higher in spring 2008, OPEC’s oil minister stated that
prices were being driven by speculators and that OPEC producers were having
difficulty finding buyers, and they refused to respond to higher prices driven
by the speculative activity in futures markets.
While prices were already falling off from the July peak, the 2008
bubble ended in spectacular fashion when Lehman Brothers’ bankruptcy set off
the global economic crisis and oil would hit bottom at just under $40 in March
2009.
The third bubble was driven by the Federal Reserve’s Quantitative
Easing (QE) policy—money printing!--and the belief it would cause
hyperinflation. This time Wall Street’s target
was retail investors who could bet on commodities through ETFs. Historically, gold and silver were the only
commodities one could buy to hedge against inflation, but financialization (and
ETFs) meant ALL commodities were game, and oil was the favorite (non-gold) flavor.
Before describing the final bubble, let me provide one indication
of how financialization has impacted oil, and in particular its
relation to the US dollar. From 1980 to
2000, a period when investors were constrained by regulations, there was literally
no correlation between oil prices and the US dollar; however, since deregulation
of commodity futures in 2000, the ability to use oil as a hedge against
inflation caused the relationship to turn significantly negative (-0.8). Today, analysts speak as if the oil-dollar
trade is some natural historical relationship, but it is a relatively recent
phenomenon, coinciding with deregulation.
The third bubble began when, at the end of October 2010, the
Federal Reserve announced it would buy $600 billion worth of treasury and
mortgaged-back securities over the ensuing six months (the policy was known as
QE2). Gold was still the major inflation
hedge, and it would increase by over $400 through August 2011. However, as confidence in the dollar’s value
fell, the broad dollar index fell by 6% by early May, and the price of oil
increased by 30% over the same period, peaking at $115. The bubble ended in a spectacular one-day drop
of $10 (one of the largest single-day drops in its history) and analysts were
at a loss to explain it, as there was no significant news to trigger the
collapse. The game was over.
Even though China’s growth slowed dramatically beginning in
2012, the price of US crude stubbornly remained above $100 until June
2014. Attempts to reflate prices occurred
over this three year period, but investors had learned their lesson: as an
asset, oil is subject to speculative hype and bubbles.
Wall Street’s attempt to hype commodities over this extended
period (2003 to 2011) helped create a debt-financed monster that has come home
to roost. While most of the fear is focused
on the shale oil boom and bust, the entire commodity sector is experiencing
what Irving Fisher (America’s preeminent economist 100 years earlier) called the
debt-deflation process. Fisher described
the Great Depression as the result of a speculative debt-financed investment boom
driven by expectations of rising prices; however, the boom engenders an equal
and opposite reaction in the form of a severe contraction as firms are unable
to pay their debt when prices fall.
The oil boom is now experiencing a debt deflation. Wall Street banks funded billions in debt-financed
investment based on expectations of rising oil prices, but collapsing prices is
now bankrupting many firms. The process
worsens as firms (and countries) scramble to generate more revenues by selling
more output. However, while it is rational
for individual countries and firms to maintain or increase production in order to
generate more revenue to pay their creditors, it is insanity for the group, as
increased supply causes the downward price spiral to worsen. This is the reason central banks are afraid
of deflation, because it leads to a death spiral among over-indebted firms AND
the banks that finance them. Wall Street
bank stocks are currently taking a beating based on this fear.
The deflationary spiral is not limited to oil, it’s hitting
all commodities. While the value of
energy stocks has tumbled by some 50%, mining stocks are down over 70%, and prices
for globally traded food commodities have also collapsed. Over the past eight years billions of dollars
were invested in US farmland by private equity, hedge funds, and pension funds at
a time when prices of wheat, corn, and soy were 50% higher than they are today. In 2014, the value of farmland experienced its
first decline since 1986. As grain
prices have continued to decline, so too will farmland values, and when Wall
Street investors try to unload these very illiquid assets, things will get very
ugly in the farm sector as well.
There is one possible bright spot. Normally falling oil (and gasoline) prices create
a boost to consumer spending, and recent retail figures are indeed positive. However, “normally” prices don’t fall from
$100 to $30 in six months. This time is
different. The collapse in commodity prices and the debt-deflation process that has accompanied it will most
likely overwhelm any positive impact from consumer spending. The big energy, mining, and farming companies
are trying to survive, hunkering down and cutting investment projects, workers,
and dividends. Consumers are usually the
last to realize the rug has been pulled from beneath the economic party.
How will it end? Financialization
means commodity prices are more volatile because investor bets drive prices. Assuming no unforeseen changes in markets
(like a serious Middle East “event”), the glut in global markets will keep a
lid on prices well into 2017, but volatility will reign because there’s no
other way to make a quick buck when interest rates are zero and heading
negative. “Smart” investors--those who
think they can time markets—will jump back in at the slightest indication of
“good news.” For example, if central
banks announce another attempt to save the markets or a group of producers
attempt to curtail production, there will be a quick jump back up in prices,
only to be brought down by the reality of “pork oil”—the glut in global
inventory and supply. The worst possible
outcome will occur if the commodity debt-deflation process pushes the US economy
into recession, which would then push Wall Street banks to the
brink—again. It could be 2008 all over
again.
In truth, the commodity bust and stock market turmoil is the
reflection of a more fundamental problem with the US economy, a problem that is
driving the populist movements of Bernie Sanders on the left and Donald Trump
on the right, inequality. And no amount
of bailouts by the Federal Reserve or negative interest rates will cure this
ill, but that’s a story for another day…
