Its obvious that the price of oil, high or low, has serious implications for financial markets and sovereign budgets. Cheap accessible energy has been the fundamental driver of economic development. It is also the major cause of conflict, a key reason the west is demonizing Russia, and the US persistence in meddling in the middle east and North Africa.
From Zero Hedge, look at the charts for oil and the US$. The petrodollar and oil move in lockstep, but inverted. As oil goes down (the cause) the US$ goes up (the effect). Bill Holter at Miles Franklin helps us see through this:
I want to mention the recent explosive move higher in the dollar. It has rallied nearly 15% in six months, and nearly 10% of this in just the last two month. This I believe is the result of the dollar carry trade unwinding. Many commodities including oil were “carried” by borrowing dollars. This was a synthetic short position in the dollar. As the commodities (oil) imploded in price, traders were forced by margin calls to exit positions. The borrowed (shorted) dollars were paid back (covered) and has caused the rally in the dollar.
The US$, the petrodollar, is the global reserve currency through its relationship with oil. i.e. the US$ is the expression of the price of oil, and the currency used for most oil transactions. US treasuries held as FX reserves in countries around the world are in large part for buying oil, or more broadly energy.
The declining price of oil is the catalyst for a chain of events that is impacting the global financial system. Here is how I connect the dots:
– oil is going down because supply is outstripping demand.
– this drives up the price of the US$ since it takes less petrodollars to buy oil.
– this causes deflation in anything priced in US$, meaning asset prices drop
– US$ denominated debt will be more costly to pay back in the future, since US$s are more costly than they were borrowed at. The rising dollar is bad for borrowers of outstanding debt (i.e. corporate and government)
– holding US treasuries (UST) means you are long on the dollar. USTs increase in value as the dollar increases, which means the yield will go down, i.e. downward pressure on interest rates
– the US has been rolling over trillions of dollars of debt, which of course are denominated in US$. Since the number of dollars they roll over does not change, they need to roll the debt over in more costly dollars. The rising US$ is good for buyers of USTs since they will be paid back in the future with more expensive dollars. On balance this lowers risk, which will push interest rates down.
So, if this flow of cause and effect is correct,
– as oil continues to drop, the US$ will rise
– all currencies will fall relative to the US$
– oil exporting countries will see currencies fall even more
– US trade balance will get creamed
– interest rates will be pushed down further
– deflation will dig in and asset prices will drop
– as collateralized asset prices drop, borrowers will need to either come up with more collateral, liquidate assets or default
The key danger points:
– declining assets prices and the need to cover collateral could spiral out of control. Bonds/loans to shale and tar sands producers are blowing up, especially if revenue streams were collateralized
– energy derivatives that were long on oil are going nuclear
– two-thirds of the hundreds in trillions of dollars in derivatives are interest rate derivatives. Half of those must be on the wrong side of the bet
With a dollar carry trade of $9 trillion invested in risk assets, the coming six months are not going to be pretty.
– Max Keiser interviews former British energy regulator Chris Cook. Great insight into some of the dealings with global energy prices. Interview starts at 12 mins, but the entire show is about oil. Basic thesis is that since 2008, QE money flowing into financial markets was looking for yield, and inflation hedging via commodities, which pumped oil and commodities up. Saudis lent oil to hedge funds, who lent money to Saudis. Oil balloon deflated when QE stopped. US and Saudis had a dark deal, guaranteeing floor at $80/barrel and US gas at pump less than $3.50 as the ceiling. If US gas went up, Saudis supplied more oil to the US. Brent at one time was $20 more expensive outside of the US. US shale oil, viable at >$100, is a swing supplier, essentially putting a cap on the global price of oil. At $91, shale producers on average were paying $130 for oil and receiving $100. At current $56, well, do the math. At $25, carnage, with only a couple shale producers viable. Wow.
– Here is an excellent article on the Russian cancellation of South Stream pipeline. Not oil, but natural gas. Europe is not happy being captive to the Russian monopoly Gazprom for a third of its energy needs. South Stream was a cynical attempt by Europe to gain control of the transmission of Russian energy. EU “energy security” is really a euphemism for the extraction of energy in other countries by its own companies under its own control, aka western capitalism. Russia did not want to be manipulated, walked away from the deal and is now looking towards China, Turkey and the east for economic partnership. “… by redirecting gas away from Europe, Russia leaves behind a market for its gas which is economically stagnant and which (as the events of this year have shown) is irremediably hostile. No one should be surprised that Russia has given up on a relationship from which it gets from its erstwhile partner an endless stream of threats and abuse, combined with moralizing lectures, political meddling and now sanctions.”
– This thread on TFMetals Report has lots of good discussion on Russian energy.
– Its not just oil. Energy is being routed and here. The price of oil has plunged 50% since June, the price of propane is down 50% since its recent high in mid-September, and natural gasoline is down 32% since recent high in mid-November.
– by ending QE the US primed the drop in oil prices. The rising US$ is deadly for emerging economies dependent on importing oil, which they purchase in US$. The chain of events is the rising dollar means emerging economies can no longer afford as much oil, which chokes off demand for oil which inflames the excess supply already in the market. In addition, EM debt, which is typically denominated in US$, are watching their debt increase as the $US increases against their domestic currency. This situation is unsustainable.
– The real cause of low oil prices: interview with Arthur Berman. The price of oil will recover. All producers need about $100/barrel. The big exporting nations need this price to balance their fiscal budgets. The deep-water, shale and heavy oil producers need $100 oil to make a small profit on their expensive projects. If oil price stays at $80 or lower, only conventional producers will be able to stay in business by ignoring the cost of social overhead to support their regimes. If this happens, global supply will fall and the price will increase above $80/barrel. Only a global economic collapse would permit low oil prices to persist for very long.
– … in this analysis, by SRSrocco, oil demand is up over previous year, but below projected growth, and price is highly elastic. Small changes in demand result in large changes in price. Further, for oil importing countries, especially emerging markets, declines in the price of oil have been offset by the increasing petrodollar relative to domestic currencies, again noting the inverse correlation between oil and the $US index.
– I am not sure what to make of this analysis, but the author suggests Saudis are being compensated for the falling oil price through CitiBank. If this is true, it would point the smoking gun for the drop in oil prices at a deal between the US and Saudis.