GLOBAL CREDIT GROWTH, INTEREST RATE AND OIL PRICE – ARE THESE RELATED?

For some years my general understanding has been that the price formation for most commercial traded materials/products/items (including oil, which is paramount for all economic activities) is very much related to credit/debt growth, total debt levels and the interest rate (the price of money which also is a measure of credit risk).

In an effort to continue economic growth (to save the system and avoid the mother of all deflations) the worlds leading central banks (US Federal Reserve [FED], the most important one as the US dollar also serves as the world’s reserve currency, Bank of England [BoE] and will the European Central Bank [ECB] soon follow?) in recent years resorted to quantitive easing (QE) and lowered interest rates to almost zero to ease the burden from growing total debt loads. QE was intended to be a temporary measure.

The central banks (CB) actions appear to be a lot about preserving wealth ({inflating} assets) while there is little they can do about nature’s CAPITAL, like energy stocks (most importantly fossil fuels).

The CBs likely pursued these measures as they had few other good alternatives. It appears that the CBs policies may also have influenced the oil markets and helped shape the oil companies’ strategies to deal with a tighter supply/demand balance since 2005 by encouraging them to take on more debt and go after the more “expensive” oil.

The world has also become more complex, interconnected and continued good growth in its Gross Domestic Product (GDP) post the global financial crisis.

CBs do not have the capabilities to create cheap, abundant and lasting energy supplies. For some limited time the world’s CBs and their policies may have alleviated (and for some time continue to) some of the effects of the growth in oil/energy prices, though this was likely not their primary objective when they deployed their policies.

WHAT SUPPORTED GROWTH IN OIL DEMAND AND PRICE FORMATION?

Econ 101 refers to the law of supply and demand as the price arbitrator for raw materials, goods and services. The credit/debt will be assumed and mortgaged against promises to honor it in the future and pay interest.

One understanding of our economies is to view them as thermodynamic flows where money is the facilitator that brings energy/thermodynamic flows to and allocate these within the economies.

During the recent decades, growth in credit/debt (borrowing from the future) grew aggregate demand and to some extent negated the price growth induced from demand growth.

The recent years continued growth in credit/debt was stimulated by lowering the interest rate. By keeping interest rates low, less revenues/funds were needed to service the consequences of the growth in total debts, and thus allowed for continued deficit spending and thus support economic activities at elevated levels.

In March 2014 the Bank for International Settlements (BIS in Basel, Switzerland) published a paper titled Global liquidity: where it stands, and why it matters (pdf file, 200 kB) which presented some interesting data and observations about developments in global bank credit/debt levels.

Private and public debt growth through the recent decades added support for the increased oil consumption and negated the effects of higher prices caused by a tight supply/demand balance. In recent years the consumers (private sector) in many Western countries are at what appears as debt saturation, and several sovereigns are trying to carry on the overall debt growth through increased  public borrowing and deficit spending, albeit at lower levels.

INTEREST RATES AND THE OIL PRICE

Low interest rates and easy credit work both sides of the demand and supply equation for oil.

Low interest rates reduce the sovereigns spending on debt services and allows companies to assume more debt  in a bid to grow. Low interest rates also inflates consumers’ assets, thus enticing (and enabling) them both to spend more and allows some acceptance for high priced oil. These factors affect spending and thus demand and the price formation for oil.

Another way to look upon consumers’ price affordability is that for the oil companies’ to become motivated to go after the expensive oil, they are dependent [betting] on the consumers’ ability to absorb the costs associated with this. This is now in direct competition with general declining wages [affordability] for consumers.

Low interest rates and easy credit allow oil/energy companies to assume more debt (increase leverage) in their bid to grow/sustain supplies which normally curtails price growth.

Easy credit and interest suppression works for some time and when interest rates start moving up and credit becomes less available, this will likely affect the supply and demand equation for oil.

Higher interest rates will lower demand for oil and thus have the potential to pull the price down.

On the supply side higher interest rates will lower oil companies’ profits from increased debt services which again lowers CAPEX to bring in new supplies. Then add for any revenue/profit effects of price changes, most likely lower prices for oil and gas.

• Which of the parameters described by the 2 lines in the chart above represents the REAL interest rate for the CAPITAL that operates the US economy (and any other economy)?
  Hint, do not confuse the price of MONEY with the price of CAPITAL.
• Which of the two parameters is most of the decisions about our future now based upon?
• The chart leaves the impression that cheap credit is an effort to offset peak cheap oil.
  At some point peak cheap credit will also be reached.

To me key financial/monetary parameters to watch are;

1)      Developments in money supply (credit/debt creation)

2)      Developments in total debt levels

3)      Interest rates (they may reveal something about expectations for future real growth)

These 3 financial/monetary parameters influence demand and supply and thus price formation.

Looking at the chart above it creates the impression that historical oil prices may also have influenced interest rates and apparently something fundamentally changed early in this century.

In the late 1970’s the FED chairman Paul Volker fought inflation, likely induced from higher oil prices from the 1970’s oil shocks with higher interest rates. The chart above shows that interest rates apparently moved in tandem with the oil price. Back in the 70’s the economies were relatively more reliant on oil as the primary energy source (refer also figure 04). High oil prices encouraged more efficient use of oil and substitution (where feasible) from oil to natural gas and nuclear.

As higher interest rates curbed inflation and fuel substitution took hold, oil demand started to decline and the cumulative effects started to affect the oil price that headed lower.

And so did the interest rate.

Growth in oil production from the North Sea, Alaska and Western Siberia reduced the reliance on OPEC supplies and in 1986 Saudi Arabia opened the taps and the market was flooded with oil and the oil price plunged. Note how the yield on the 10 year US Treasury (UST) in the mid 1980’s dropped significantly as the market was flooded with oil and took the oil price down.

From 1986 until early this century the oil price remained fairly stable in the $20/Bbl range. During this period the interest rate was on a steady course towards lower levels.

Apparently the economy entered new territory sometime in the middle of the last decade as it appears higher oil prices (even if the economies had become more efficient) did not do anything to the interest rate that continued its downward trajectory.

With the dotcom and  later the housing bubble, monetary policies sought to lower the interest rate primarily in an effort to grow asset prices and entice consumers to take on more debt to continue spending.

This while the oil price went hyperbolic.

As far as there historically has been a linkage between the oil price and interest rates, this link was likely severed by governments becoming the driver of economic growth sometime in the second half of the previous decade (the 00’s).

The higher oil price in the 1970’s made the world modify its energy mixture by lowering consumption of “expensive” oil by primarily substituting with natural gas and nuclear. As the oil price remained at a lower and stable rate, as from the mid 1980’s until early this century, oil’s share in the world energy mixture remained fairly stable. As the oil price went hyperbolic, coal’s portion of the world energy mixture started to grow while oil’s declined. This leaves the impression that continued growth requires cheap(er) energy.

The central banks’ monetary policies now appear to face new challenges as described in the article Out of Ammo? The Eroding Power of Central Banks (The article is a worthwhile read and contains some good charts about central banks’ balance sheets, interest rates and comments on the financial and the real economy.)

“But then, as deregulation and globalization took hold, the financial sector becomes increasingly separated from the real economy, following the self-fueling logic of speculation, under which a bull market feeds a bull market and a bear market a bear market.

In attempting to control the economy, the central bankers created “a monster,” as former German President Horst Köhler once put it. They have become hostage to the financial industry.”

OIL CONSUMPTION WITH CHEAP, EASY CREDIT

Asset values {consumer wealth} are closely linked to consumers’ willingness and abilities to spend (consume).

Low interest rate improves consumers’ affordability for expensive oil due to cheap credit {less debt service} + the wealth effect from inflated assets => allows oil companies’ to go after more expensive oil => Demand remains high and supports price

High interest rate => reduces consumers’ affordability (due to increased debt services and deflated assets {reduced wealth}) => curtails the oil companies’ abilities {increased debt service} to go after expensive oil  => Demand declines and likely also the price

I hold it likely that the cumulative effects of a slowdown in debt growth [possible deleveraging] and higher interest rates will lead to a situation where demand declines faster than supplies, thus exerting a downward pressure on the oil price.

These days there are now more factors that influence the oil price than 2 decades ago.

1)      The easy, cheap oil has come to an end

2)      Emerging economies have been growing their consumption.

Brazil, Russia, India, China, South Africa (BRICS) is so far different stories as these as of recently have had more expansive credit creation that also allowed for growth in oil consumption and helped cope with the high oil price.

Below I present a closer look at some regions and how their petroleum consumption responded  in recent years to changes in credit/debt growth and interest rates.

Total petroleum consumption in European Union (EU) and USA has declined with more than 4 Mb/d (or around 12%) since its high in 2005.

Lower interest rates and continued growth in total debt (refer also figure 01) helped cope with higher oil prices and curtailed the decline in consumption.

The causes and effects debate will likely continue.

The chart suggests that the EU and USA now may be able to handle oil prices in the $100 – 110/Bbl range with reduced deficit spending (which still increases total sovereign debt), low interest rates and some austerity measures.

If budgets were to become balanced or result in surpluses, thus allowing for deleveraging, this has the potential to take money out of the system and thus reduce oil demand and weaken price support.

During a few months in 2008 under what is commonly referred to as the start of the global financial crisis (GFC), the global demand for oil declined around 4%, while the price declined about 70% from its peak in July 2008 to December 2008.

No one can issue any guarantees that future financial turmoil could introduce similar discontinuities.

China was, according to data from the International Monetary Fund (IMF) the world’s 2nd largest economy in 2012 and Asia Pacific’s biggest.

Brazil was, according to IMF data, the world’s 7th largest economy in 2012 and Latin America’s biggest.

From 2005 to 2012 total petroleum consumption in Brazil and China grew with around 4 Mb/d, or 36%, which are about the same total flows EU and USA reduced their consumption with.

The impression created from the chart above, when held together with the panels for the respective regions in figure 01, is that growth in debt/credit made it possible for Brazil and China to soak up oil flows which the EU and USA gave up as these struggled with the effects from their total debt loads and the feeble growth in the world’s oil supplies since 2005.

Easy credit and low interest rates appear to have supported petroleum consumption in the EU and USA and assisted in coping with the high price.

Higher interest rates (I believe) will result in a demand driven lower oil price that will leave the impression that the world is awash with oil, while in reality it will be an affordability issue. A lower oil price will also make the oil companies spend less to bring in new supplies.

A (temporarily) demand driven lower oil price comes to the prospects of disguising the true state of the world’s crude oil supply systems.

OIL CONSUMPTION FOR NET OIL EXPORTERS

Oil prices also affect demand/consumption in countries that are net oil exporters.

Between 2005 and 2012 total petroleum consumption in those countries that were net oil exporters in 2012 grew with 2.7 Mb/d or around 17%. This in response to the higher oil price which again was endured by growth in total credit/debt and low interest policies in big economies that imports oil.

Note that with the lower oil price in 2009, petroleum consumption in exporting countries declined slightly.

Growth in petroleum consumption for exporters correlates with the oil price. In this post, it is also shown that global growth in total bank credit has played a role in sustaining demand and allowing for higher oil prices. It should be expected that future deleveraging and possibly higher interest rates will affect demand and the oil price. As some of the exporters needs a high oil price to fund their budgets a lower demand and lower oil price is also likely to lower demand for oil in oil exporting countries.

This becomes thus a self reinforcing feedback loop that lowers oil demand further.

HOW OIL COMPANIES RESPONDED TO HIGHER OIL PRICES, EASY CREDIT AND LOW INTEREST RATES

This Week In Petroleum (TWIP) from April 16 2014.

The chart above from EIA considered 42 U.S. and international oil and gas companies that have reported upstream expenditures since 2000. For the last few years, it shows a decline in cash from operations, while long term debt has grown while investment activities remained flat and possibly may decline in the near future. As commercial oil companies have their eyes on returns (oil companies are in the business to make a financial profit) and thus needs to please investors, the effects of lowered investments (CAPEX spending; CAPital EXpenditures) will at some point also affect supplies.

What could be wished for was that the chart also included the development in crude oil production for the oil companies considered.

The growth in debt shows that free cash flow have not sufficed for CAPEX (investments) and dividend payments this while oil prices remained high and stable as from 2010.

Low interest rates compelled oil companies to issue more debt that was used for acquisitions, stock buybacks and   CAPEX.

What the chart above illustrates is that the oil companies in a bid to go after the more expensive oil (like the Arctic, shale oil, the deeper water, etc.) took on more debt and so far this has materialized in little production growth for liquid petroleum (primarily crude oil) and with little or no effect on returns.

Higher interest rates will divert more of the companies’ revenues towards debt service. As higher interest rates bring with it the prospects for a lower oil price, the cumulative effects of these will further impair the companies’ investment activities.

Higher interest rates and lower oil prices will make the oil companies curtail their capital expenditures and defer plans for exploration and developments that require a higher oil price to meet their requirements for return.

Companies stock buybacks may appear as management is aware of the growth prospects and therefor becomes more occupied with stock rigging to please shareholders.

RENEWABLES RESPONSE TO EASY CREDIT AND LOW INTEREST RATES

Taking a look at the growth in renewables, solar and wind, their period of hyperbolic growth coincides with low interest rates and easy credit. This growth was also buoyed by policies (subsidies) that was intended to increase the generation of electricity from more environmentally friendly sources and reduce the dependency on fossil fuel imports.

Solar and wind was 1.1% of world total primary energy consumption in 2012 based upon data from BP Statistical Review 2013, which does not include biomass.

SUMMARY

To me it now appears we will move into uncharted waters where the effects of complex nonlinear dynamics sourced from total global debt loads, central banks yield curve shaping [long bond price fixing] to ease the burden from total debt loads and to facilitate issuance of more credit/debt, are all about to meet up with the realities from less accessible and more expensive resources (CAPITAL) needed to fuel continued and real economic growth. The durability of the central banks’ policies and what other tools that may be deployed remains to be seen. These policies will also affect energy affordability.

Our concept of CAPITAL is distorted as the financial system does not recognize energy for what it is and our decisions are based on man-made constructs like the interest rate (nature does not operate with interest rate).

Credit/debt growth together with low interest rates appears to have played a part in both growing demand for oil and negating the price growth from a tighter supply and demand balance.

If interest rates move higher for whatever reasons this will also affect demand for oil and thus oil prices. A global deleveraging by any means (down payment of debt, defaults, etc.) will affect the demand for oil and thus the price.

A lower demand for oil now, as supplies show signs of growth, should if the market was left to itself, result in lower prices. Interference from cartels and/or events of major geopolitical characters may counter any organic market corrections to the oil price.

…

As I did the research and discussed the contents of this post, “Herbert Stein’s Law” repeatedly came into mind, which Stein expressed as;

“If something cannot go on forever, it will stop.”

By which he meant that if a trend cannot go on forever, there is no need for action or a program to make it stop, much less to make it stop immediately; it will stop of its own accord.

“Wisdom comes to us when it can no longer do any good.”

• Gabriel García Márquez,  Love in the Time of Cholera

A lesser known corollary is;

“Experience is something you get, just after you do not need it.”