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By HaleStewart December 11, 2014 4:17 pm
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International Economic Week in Review: The Oil Must Flow, Edition

     I'm traveling this weekend, so this review is a bit early.

          Over the last month, OPEC announced it would not lower its oil output.  Analysts interpreted this decision as OPEC’s attempt to sink oil prices below levels at which fracking companies are profitable.  This would (hopefully) force at least a small amount of bankruptcies in the oil patch, thereby leading to lower US production and higher prices in the long-run.  Oil prices have certainly dropped sharply since the announcement.  But the overall analysis as to what will happen has been scattered.  The purpose of this article is to explain what is happening in the oil market and what the implications are for central bank policy along with the oil industry in general.

          Let’s start by looking at the weekly chart of oil, which had three general levels of support: 80, 85 and 92.5.  Prices stayed at the 92.5 area for a few weeks, after which they moved sharply lower, essentially crashing through the 80 and 85 price level.  There was also an uptick in volume and a several technical breakdown: all the EMAs are moving lower, momentum is clearly dropping and overall prices are relatively weak.

          Whenever there is chaos in the oil market, I turn to Professor James Hamilton, who has written extensively about the oil market.  Here is his conclusion:

So here’s the basic picture. The current surplus of oil was brought about primarily by the success of unconventional oil production in North America, most new investments in which are not sustainable at current prices. Without that production, the price of oil could not remain at current levels. It’s just a matter of how long it takes for the high-cost North American producers to cut back in response to current incentives. And when they do, the price has to go back up.

This conclusion backs-up OPEC’s logic: drop the price to shake out the weaker companies in the US and Canada who have a higher fixed cost for production.  This will lead to some bankruptcies which should lead to a drop in Canadian and US oil exploration, lowering overall production and therefore, leading to price increases.

          There has been a fair amount of doomsday predictions for the oil industry as a result of this development.  But this analysis misses many capitalistic nuances that will greatly mitigate the contraction.  The doomsayers first focused on the junk bond market, arguing we’d start to see waves of defaults.  This argument overlooks the fact that most of these issues will be re-negotiated; borrowers, after all, would far rather get paid on delayed terms rather than defaulting.  In addition, some of the smaller, less financially stable companies will be purchased by the larger oil companies, leading to industry consolidation.  Although there will be some bankruptcies, their number will be far smaller than many of the click bait headlines are projecting.

          There are several important macro-economic developments from oil’s price drop, starting with a more favorable consumer spending picture.  Oil demand is very inelastic; as gas prices increase, consumers shift discretionary spending to energy costs.  The opposite is also true.  In addition, this price drop is occurring at a very fortuitous time – the holiday season.  While we won’t know the final sales tabulations until after the holidays, don’t be surprised to see a solid pick-up in holiday sales across regions – the US, EU, Japan, China … everybody.

          Secondly, lower oil prices means lower inflation. This will have far more salience to the US and UK, where the central banks are far closer to raising rates than the central banks in the EU and Japan.  However, this news could conceivably push US rate hikes back a bit, which would allow labor market slack to tighten a bit more.  This could also potentially increase the deflationary spiral in the EU, where oil’s price drop is having a large impact on their overall inflation rate.  We’ll know more about these effects over the next few months.  Pay particular attention to meeting minutes.

          Third, this could have a material impact on the trade balances of oil importers, such as the US, Japan and China.  The degree, again, is highly variable. 

          But, most importantly, this will be a temporary aberration, lasting at most 24 months.  At some point, supply will drop sufficiently or demand will grow sufficiently (spurred on by increased growth caused at least indirectly by lower oil prices) to move prices back to the $90/bbl+.  I think we’ll see a combination of low gas prices spurring growth and demand followed by a slight contraction in US/ Canadian production (say a drop of 20%) that will cause prices to move higher.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer

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