The oil market is continuing to blow a gasket. Yesterday, the US oil benchmark, West Texas Intermediate (WTI) for June delivery, fell hard again.
This time it was related to an oil exchange-traded fund (ETF) dumping a whole load of oil contracts so that it doesn’t end up getting caught out by the same negative oil price issues that arose a week ago.
We discussed all the technicalities behind that last week. What’s more interesting to me today is this – how did we end up with this massive glut in the first place? And what does it tell us about the wider economy?
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The real reason the world is swimming in oil
Oil is fascinating. It’s a microcosm of the bigger picture economic problem we all face right now. There is too much oil in the world. That has been brought to a head by the coronavirus resulting in a collapse in demand. But it’s been brewing for some time.
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It’s perfectly normal for “hard” commodity prices to undershoot and overshoot. It takes time and money to find and produce oil or other resources. You need to get permission to explore, then you need to explore, then you need to find something, then you need to get permission to dig or to drill, then you need to dig or drill, then you need to shift it from one place to another – it’s a monumental undertaking.
So the industry is always out of sync with the underlying cycle. Demand outweighs supply so prices go up. Suppliers notice prices going up, so they try to produce more. That takes time, so prices keep going up. Eventually though, there’s a glut as supply all comes online at roughly the same time. Prices fall, producers cut back, and so the cycle goes round and round.
But for oil on this occasion, there’s been a bit of a glitch. The rise of US shale has turned everything upside down.
US shale came about in the first place because in the run up to the 2011 commodities peak, oil prices soared. It became worth looking for oil anywhere you could find it, because we were approaching “peak oil” – we were running out. $100 oil made almost any source viable.
However, while expensive oil might have kicked off the shale revolution, something quite different has kept it going – low interest rates and cheap credit.
As a result, shale oil producers have been able to keep going even although the vast majority of them don’t make any money. This is an industry that would have mostly closed down by now if it weren’t for the wildly forgiving monetary backdrop that we are operating against.
This means we have a group of essentially price-insensitive producers battling it out to be the last man standing. And this is how you end up getting something as ridiculous as negative oil prices.
We’re destroying the fabric of capitalism
This is all symptomatic of a bigger problem that we have right now.
In his Bloomberg newsletter this morning, John Authers takes a look at a recent report from Jim Reid at Deutsche Bank. Reid takes a look back at historical default rates – companies going bankrupt – in the US since 1970.
To cut a long story short, even although credit quality has been getting worse (and it's very bad right now), default rates – even during recessions – have been going down. Why?
Because, as Authers puts it, “taxpayers are prepared to do far more to prevent defaults.” In other words, the bailouts keep getting bigger and bigger.
Here’s the problem with that. And I know I’m repeating myself, but this is important.
The reason we have free markets and capitalism is because they have proved to be one of the best methods of allocating scarce resources that we have yet uncovered (note that being better than other methods does not imply perfection – just superiority to other methods thus far tried).
If resources are put to good (efficient) use, then they will turn a profit and the business or industry will attract further resources until it stops being profitable. If the resources are not put to good use, then they won’t turn a profit. That will lead to bankruptcy, which then leads to the redeployment of said resources by someone who thinks they can do a better job.
The point of bankruptcy is not to ruin people’s lives or to cause depressions. The point of bankruptcy is to allow resources to be put to better use. That’s it. (This is why bankruptcy laws shouldn’t be punitive and why unemployment safety nets should be generous, but this is a topic for another day).
Bankruptcy helps us to see what’s working and what isn’t. If you effectively get rid of bankruptcy, then bad ideas thrive. In fact, it’s worse than that. The good ideas end up being suffocated under the sheer weight of all the bad ideas out there, because bad ideas are generally easier to pursue than good ideas.
How do we know that this is a problem? Because as Authers points out, Reid highlights a clear relationship between corporate default rates and productivity.
“The positive side to defaults, if there is one, is that it stops inefficient businesses from draining capital, and allows banks and investors to look for projects that have a better chance to grow,” writes Authers.
"An environment with ever lower rates and predictable intervention to avert defaults is also an environment in which we might expect productivity to endure a steady decline. And Reid’s numbers suggest that that is exactly what has happened.”
This is what happens when you persistently ignore moral hazard. If you avoid consequences today then you end up with bigger consequences tomorrow.
This is depressing. But it’s also human. We all do it. That’s what makes it so predictable. If you want to know which option society will choose on average, then you simply go with the path of least resistance. And the path of least resistance is always the one with the fewest short-term consequences.
Eventually, we’ll switch to another path. But it’ll be because the short-term pain becomes too great for us to continue on the current path. And that’s why I think that we keep going down this route until an inflationary crisis forces us off it. And that’s not for a while yet.
So expect financial repression, increasingly overt deficit monetisation, and all that good stuff. And as for oil prices – well, I imagine they’ll shut down production completely at precisely the wrong moment, as that’s what usually happens.
For more on all this, and its impact on your portfolio, do subscribe to MoneyWeek magazine. Your first six issues are completely free and we’re also giving away a free ebook on some of the biggest crashes in history – some of it might provide a useful guide as to what will come next.
