Oil capex, resource misallocation and the global growth slowdown
The first time I wrote about shale oil resource misallocation in the wake of lower oil prices was back in October 2014, exactly a year ago. A lot has happened in that year, so I want to look back at the oil-related posts I have written in that time frame and recap the overall message. As it stands today that message is that oil price declines have two major effects, one positive and one negative. The positive is the dividend to consumers. The negative is the loss of capital investment and jobs in the oil sector. Which one will be more important is not yet clear, but today I will focus on the negative.
Here’s how I positioned the story a year ago: “he huge investment in shale oil is an artefact of Fed policy because of the unique investing pre-conditions low interest rates, quantitative easing and forward guidance have created….”
“This is where the Chinese rebalancing enters the picture. After last year’s third plenum, the Chinese became serious about moving from the export and infrastructure-led growth model they had followed to one in which domestic consumption mattered more. And to make this transition, it would mean a slowdown in commodities and energy consumption growth as the economy slowed during the rebalancing…
“What we should be concerned about here is that, just as with subprime mortgages, this is not a particularly big market but one with interconnections to others. The leveraged loan and high yield market could be affected and other riskier US debt markets like student loans or auto ABS could be affected by sentiment. Right now, it is still early days. So the oil price might even recover. But the abundant liquidity of zero rates, resource misallocation and shale oil simply do not mix.”
Looking back, all of this still seems to make sense. However, the pace of change has been much slower than what I wrote suggests it would be. The extend and pretend game has been a big factor in terms of banks rolling over loans. But companies have also been very good at lowering breakevens through making cost reductions and using technology. So we are still at a point today where we await enough “market death” for supply and demand to come into balance. And I do not believe prices will rise until we see significant bankruptcies and consolidation.
Already by November of last year, I was flagging the negative implications of the fall in oil prices, despite the growth dividend from greater consumer disposable income, because of what I was seeing in deepwater drilling – a universe that was not related to shale but that also had high breakevens. “The interconnections here then suggest that the fall in oil prices will significantly impact capex. CERI President Howard admitted that oil sands projects in Canada will be cancelled at these levels. And Transocean has told us that deepwater drilling rig count has already been significantly affected.”
Back then Warren Mosler was talking about a negative print for Q4 2014 US GDP. I wasn’t onboard with that call but if you recall, Q1 2015 was initially negative and generally very weak. I believe oil capex had a lot to do with this – and has helped create a see-saw pattern to GDP figures. I haven’t seen any calculations of how much GDP has been depressed by the loss in oil capex and its multiplier but here’s what I was saying about downward Q4 2014 revisions and coming poor Q1 data in February:
“In the US, the reduction in capital expenditure will have a meaningful impact on GDP growth as well. I believe the 2.6% number for Q4 2014 was in large part due to a reduction in capex, much of it coming from oil. The drop in oil prices helped consumers to a 4.1% annualized gain in spending, but business spending was down an annualized 1.9%. I believe these GDP figures will be revised lower as the effects of capex reductions filter through into the numbers. I thought we would have risen to a 3%ish growth rate last quarter before revisions brought it back in line with my 2%ish baseline. But, the 4th quarter was so weak that 2014 US GDP came in at 2.4%, meaning we are still trending in the 2%ish level, even before the negative capex data comes online.”
This assessment turned out to be correct. In terms of policy choices coupled to these data, I would say that though the Fed’s policy choices are data dependent, the bias is clearly on the tightening side. At that time, I wrote that the Fed had not incorporated the downshift in growth into its thinking and that a GDP growth drop into the 1’s would alter the Fed’s timetable. And I think this is still the case: tightening bias and data dependency means that weak data put the timetable off. And much of the weakness will be driven by what’s happening in the oil sector.
Before I make any more forward-looking comments, I want to say upfront that I think we have witnessed a massive misallocation of resources due to low nominal rates favouring long-lived projects and bets that have long-term payouts like shale oil (or Tesla Motors as another example). At the same time, capital investment has been low in North America and Europe. In the US, firms have been more concerned with buying back shares than making incremental capital investments. My view here is that the weak capital investment environment mixed with the skew of capital investment toward long-lived assets is a priori evidence that the low nominal rates are inappropriately low for market-based resource allocation decisions. In essence, the Fed has kept rates low because of a depressed real economy where it has had very little impact while the financial economy has been greatly impacted in terms of resource allocation and equity discount rates. This excess will be unwound.
So where are we now? On the consumer side, low prices have had a positive impact. Just yesterday, the Wall STreet Journal detailed how consumers splurged with their gas savings. And this makes sense since wage growth has been weak, meaning that consumers with high marginal propensity to consumer are going to use the additional money not just to save or pay down debts, but also to spend.
Yet at the same time, the situation in the oil complex is serious. I believe we are on the cusp of market death, the big shakeout that we have anticipated for months now. A lot of this is driven by accounting. As I wrote in April “the clock is ticking in terms of the balance sheets of producers, who have to account for oil assets at the average price for the last 12 months. When July hits, we will be in a situation where there are going to be big markdowns to oil assets on balance sheets and that will negatively impact, loan collateral ratios and borrowing capacity.
“In essence, there is a ticking time bomb lurking at the heart of the oil industry right now. And the only thing that can defuse it is an increase in global demand. My sense here is that global demand is not going to rescue us. The trade numbers out of China this morning showed a double digit decrease in both exports and imports, indicating sluggish global demand growth that I believe will persist for some time to come.”
“The likely outcome here is market death on a mass scale in the second half of 2015 and in 2016. We saw the early jitters from market death last year as the high yield bond markets reacted to the decline in oil prices. But things have stabilized since then. However, I believe we will see an oil market crisis develop as market death takes hold. And the baseline scenario here has to be for market volatility and some degree of contagion.”
The asset revaluation process is happening as we speak (FT, WSJ). And this is due to the reserve-based lending banks have done in shale. The OCC is coming down hard on banks about these loans. So the extend and pretend game may be over. When this process is finished, I believe some companies are going to see their credit lines frozen or potentially reduced. And that will mean consolidation and bankruptcy.
In the meantime, global growth continues to slow, especially in emerging markets. But given the impact that the depression in the oil sector is having on jobs and on capital expenditure, I believe the US economy is going to slow materially from here. Again, I am not yet talking about recession because none of the numbers I see show recession. But I believe the slowing has been enough to bring down trend job growth and trend economic growth, though jobless claims have yet to show any impact. I further believe that this decline in trend will alter the Fed’s outlook and rate hike path. We very well could be back into a permanent zero situation, with the Fed stuck on zero for the foreseeable future.
Tomorrow I intend to discuss Germany because I also see slowing there due to the weakness in manufacturing and exports.