Your Money or Your Life

Since I first mentioned likely problems of the falling price of oil, the price has dropped even further.  It is at this moment trading at $58.02. down 3.2% since the market opened today.  Traditionally, this would be welcomed without reserve since it is a tautology that lower energy prices generates extra income to be spent for nearly everyone involved, which happens to be in fact nearly everyone.  Even babies benefit.  And though this particular observation about low prices still holds true, the current episode of falling oil prices, dramatically I might add, is almost wholly bad from a market perspective, completely negating the benefits and then some.

There is a building yammer in the financial press as journalists unwind the implications of this rare occurrence.  A glance at some headlines from the past couple of days give us a flavor:

IEA cuts 2015 demand growth forecasts, warns on social unrest

Fed Bubble Bursts in $550 Billion of Energy Debt:  Credit Markets

The Silent Crash in Commodities- A Warning Sign

This is all pretty grim stuff.  Of course, you'll see alongside these headlines something like:

Schwarzman:  Energy a 'Wonderful Opportunity"

This last actually doesn't contradict the point I make about falling oil (and every other commodity), Schwarzman just believes in eternal economic growth, so naturally this is an opportunity.  In the short term he could still very well be correct to buy up shares of energy companies, the right ones anyhow, and make a fortune because if there is any lesson to be had it's that energy and other commodities need to be priced much higher than they are now so that suppliers can remain in business.

Charles Hugh Smith has had for a couple of weeks now a series of blogs on the problems and risks to the financial system from low energy prices.  This subject has a ton of different components and wending your way through all the moving parts takes some time.  It's worth reading because he treads where many financial analysts fear to go, which is in the dark shadows of the quasi-legal credit markets which support new American oil production and describes it well.  The key phrase he uses is the "financialization of oil", which is to say that Wall Street and the Oil Patch are bound together through debt and collateral.  The collateral of course is oil.  The debt for this oil often comes in the form of a junk bond, meaning high interest loans that are at high risk for default.  But it goes well beyond this.

The bonds used to fund oil projects themselves become collateral for other bonds issued somewhere else.  This is because the bond itself is considered an asset and so has a trade value which can be used to support a new loan.  In this way, a bond is not so different from money, and in fact, lending is the primary means by which money is introduced into the financial system.  The banks try to earn a profit from this market of credit and bond accumulation and trading by playing the yield (interest rate) differentials as well as through fees paid to issue the loan. 

So far we're in the realm of the normal.  What's different now, well, there's a lot that's different now, but one major difference is the magnitude of the debt held by participants in a magnificent web of creditors and debtors who all have to be "good" to cover their individual nodes of credit in the system.  The "dominoes" in Charles Hugh Smith's little essay refers to what's called "counterparties" who have to pay off their debt when asked to.  When someone, like a bank or oil company, has 10x or a 100x the amount in loans issued to the amount they have in collateral, then they will probably have to sell something in order to cover what they owe someone else.  What is happening now is the original collateral, oil, has lost 40% of it's value since June.  A predictable outcome to all of this, which is going on right now as a result, is the high interest, high risk junk bonds are trading at values as low as sixty cents on the dollar.  These could very well be on there way to zero cents on the dollar.  We shall see.

Even what I've described so far is still within the realm of a fixable norm.  If it were simply a phenomenon exclusive to this isolated shale revolution, and there was no other problem with global oil production, then it's impact would be isolated.  But because it is tied in with other aspects of global finance, such as currency markets, and revenue for the national governments around the world who export oil (a relative few actually do), it becomes a global problem with huge geopolitical risks.

As for currency risk, a counterintuitive impact is the risk of a stronger dollar (strong=good), but what has been the case for a while now is that the dollar, as the world's reserve currency, is becoming increasingly unavailable to markets around the world who need them to buy things and to pay off dollar denominated debt.  This is caused by simple supply and demand.  There are fewer dollars in the system and so the increased demand for them drives up its value, making it "stronger".  This could end up as what's called a "liquidity crunch" in foreign markets, where there is not enough dollars to go around.  In an historical note, a liquidity crunch was in process in the 2008 credit collapse and prompted action by the President and Congress to, in effect, print more dollars.  It is the same reason the Fed had been "printing" money up until earlier this year, and might do again before too long.

In a previous post, I posed the question:  How many failed states does it take to make a failed world?  Nobody knows, of course, but the oil price collapse is testing the limits.  Oil revenue which funds all sorts of government programs is dropping well into the red for all sorts of countries.  Nigeria, Venezuela, Russia, and Iran, are flirting with the risk of joining the ranks of failed states.  Some 370 million people live in these countries.  They are all oil exporters.  We, as American patriots, maybe wouldn't mind seeing an overthrow of the current regimes in these countries, but nothing is guaranteed once social upheaval is on the dinner plate.  Think Iraq or Libya.  Or even Egypt, which filled our hearts with so much hope and promise, and is now back to a military dictatorship with no prospect of ever joining the league of free nations.  That may sound overly bummerish but I don't see how that ever happens.

What is happening is that the nexus of oil, money, and debt is revealing itself to the market.  It's not too simple to say that money is energy, and oil is the most valuable source of energy for the globalized industrial economy.  Money and oil share a lot of characteristics, one being they need to be believed in for the market to function.  Debt is future money, which is future oil, and a whole lot of future oil needs to leave, or never enter, the future economy because there is no future money in it.  Giving that up will be traumatic, though I'll leave on a somewhat optimistic note in that leaving lots of oil in the ground will help future humans a lot by taking the edge off the consequences of a warming planet.  What might preclude that benefit is how well we humans deal with trauma.