Thursday, January 29, 2009

Endgame 8: Energy, Debt and Bonds

As oil has plummeted in what I term a "head-fake," we foresee a volatile and disruptive interaction between debt, bonds and energy supply/demand and price.

Back when oil was shooting up over $100 a barrel, I suggested that the coming global recession would cause oil prices to crash in a "head fake" which would create an illusion of plentiful oil. Here's the chart (apologies to longtime readers who've seen it too many times already)

And here's a few recent entries on the topic:
Oil: One Last Head-Fake? (May 9, 2008)
Checking In on Oil's Head-Fake (September 18, 2008)
The End of Leverage (December 13, 2008)

What I want to expore today is the confluence of debt and energy. What we're seeing now is governments around the world borrowing and spending several trillion dollars in fiscal stimulus; the U.S. alone has staked several trillion dollars in borrowed money on rehabilitating its crippled financial sector and is now set to spend another $800 billion on direct goosing of the economy.

European and Asian nations have announced their own stimulus packages, and all but China's will be financed by the sale of government IOUs/bonds--in essence, borrowing the money from those with surplus capital looking for "safe haven." (And with tax revenues dropping in China, perhaps even that government will soon be borrowing to support deficit spending.)

But as China's economy craters (and with official statistics ginned up, who can tell what's really happening there) and the oil exporting nations' gusher of profits vanishes, then just who has the trillions of dollars in surplus to fund this mighty paroxym of panicky government borrowing? The most reliable buyers of U.S. debt/bonds were the exporting Asian nations (Japan and China) and the oil exporters (Saudi Arabia and Gulf oil states).

Now that oil has fallen drastically, the oil exporters are finding they face not wellsprings of endless billions of excess capital to invest but billions in deficit spending. As noted here many times, demographics are a tightening vise in all the Gulf oil states: their population is booming, as is their welfare-state spending, even as their revenues crash.

Even worse, the need to fund their welfare states will draw funding from whatever they planned to invest in their oil infrastructure/future production capacity--and for most oil exporters, even those sums were too paltry to maintain current production, never mind boost supply.

This is the real killer effect of the head-fake: investment in future production capacity will drop to zero as the ruling elites spend every dime on suppressing their restive, welfare-dependent populaces. So when demand does pick up again (let's say in 2011-2012, if not sooner) then supply will be far more constrained than it is today.

Recall that it takes years of stupendous investment to extract more oil from any source; the cheap, easy-to-get stuff is already gone. Even the Saudis are spending tens of billions of dollars to maintain production.

How long can these nations (including Iran and Venezuela) continue their welfare spending/ subsidies if oil keeps falling in price? No one knows, but the clock is definitely ticking.

The one thing we know for sure is that their excess capital which once bought U.S. bonds is gone. The same is true of China: now that nation must redirect its surplus capital into its own domestic economy/welfare spending.

Put this together and here's what is taking shape:

1. The tremendous fiscal goosing by all governments will create a temporary floor under oil's relentless decline. Spend a couple trillion dollars and you will certainly create some demand for oil which would otherwise not exist.

2. Thus we can anticipate a rally in oil/natural gas prices, and the illusion that the "head-fake" decline is over. Once the stimulus spending has run its course, however, then demand will fall again and oil will resume its head-fake fall--perhaps all the way down to test its 1998 lows around $12/barrel.

3. Oil will stabilize in price, but at a price too low for oil exporters to support both their welfare states and investment in their oil infrastructure. They will of political necessity choose welfare spending thus allowing their oil production to fall into irreversible decline.

4. As governments from Japan to Germany borrow heavily to fund their desperate fiscal goosing, they are tapping not an endless supply of money but the last few feet of muddy water at the bottom of a fast-drying well.

The big global surpluses of capital sloshing around the globe looking for a nice fat return are over. Everywhere assets are depreciating/falling in value, payrolls and profits are declining, and with the popping of global asset bubbles, nothing is even remotely in place to change those trends.

5. Thus at some point the voracious appetite of governments to sell debt/bonds to raise cash to spend will run headlong into the stone wall of declining supply of surplus capital. It all comes down to supply and demand. We speak of the Fed "printing money" but as others have shown, the governments don't actually print money and spend it: they create lending via fractional reserve banking, but the fiscal stimulus funds are borrowed in the bond market.

Once there's not enough supply of capital to buy all the bonds being hawked all over the world, then the prices of those bonds will have to rise to draw funds out of other investments. It is thus easy to anticipate yields doubling and then tripling as governments compete for scarce capital. (And rising yields equal rising interest rates.) there simply isn't enough surplus capital to fund new mortgage debt, new corporate debt, new local government bonds and the fantastic sums being borrowed by central governments.

6. In the big picture, the global economy is squandering the last cheap oil to fund fiscal stimulus of economies based on cheap, abundant oil instead of spending those borrowed trillions on a less-oil dependent energy infrastructure.

The net result of that global mal-investment will be an eventual resurgence of demand for oil which is far higher than available production/supply. Once the "head-fake" is over, then this mismatch of supply and demand will sent oil prices soaring to heights few anticipate now--$300/barrel seems entirely plausible--and make supply unpredictable.

Frequent contributor U. Doran recommended these oil-related articles:
OIL RISES, OIL FALLS: The History of Oil Meets the Perfect Energy Trifecta
What’s next on the energy roller coaster?

More to read:

The Long Emergency: Surviving the End of Oil, Climate Change, and Other Converging Catastrophes of the Twenty-First Century by James Howard Kunstler
Beyond Oil: The View from Hubbert's Peak The Party's Over: Oil, War and the Fate of Industrial Societies The End of Oil: On the Edge of a Perilous New World
Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy

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