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Econ 101 for Oil

Many in the oil market seem to have forgotten Econ 101.  To bring everyone on the same page, below is meant to be a refresher in case you forgot, never learned or just didn't care.

First, a demand curve goes downward from a high price and a low quantity to a low price and a high quantity.  For example, at $15 a beer, you tend not to consume very many beers. But at 15 cents a beer, well......  

Supply curves are just the opposite.  They go from a low price and low quantity to a high price and high quantity.  So if you are making hot dogs at a food truck the price and the quantity would be:

If you can only sell hot dogs for 50 cents, you might  just stay home and sell zero.

But if you can sell hot dogs for $10, you are going to want to sell a zillion. 

If all of a sudden Costco has a sale on hot dogs and you can buy them for 10 cents each, then at every price you want to sell more hot dogs than before.  

For oil markets, the fracking/horiz/new technologies has meant that for every price, there is more oil.

Thus in the short-run (weeks), the following chart shows the impact:

But over time, things change. For example, at a low price most people will not buy a BIG car, fly more and in general use more oil. It takes time to schedule a vacation and buying a car is not done very week. But over several years, people will respond to low prices by increasing the quantity demanded at every price point. This is reflected in the charts below:

Notice how a price of $50 is required to clear the markets in the short-run, but a price of $90 is required in the long-run.  This basic difference is a reason commodity markets can be very volatile.

Prices can go up by 100% or down by 50% in a very short time. To clear a commodity market in the short-run, prices have to go crazy.

This is why farmers want various programs to stabilize the price of corn (or other products).  In oil, OPEC has preformed this role by increasing or decreasing production to stabilize the price. 

But when OPEC decides not to stabilize the price, the impact can be more severe than if OPEC did not exist. Many people planned on OPEC to provide stable prices and thus planned their actions on this assumption.   But when OPEC decides NOT to decrease supplies to stabilize price, the price needs to change more than normal and will stay lower longer than normal to cut production and stimulate demand.  

Last, but not least, is the question: How long is the short-run vs long-run?  When does the demand and supply curves change to less elastic curves?  This has been a question on the Investor Village Board BRY for the past week.  Some very good posters have argued that the supply and demand response would be fast, while others argue the supply response will take years.  How fast is the response?  Anyone who says they know for sure are wrong (even if in this case they lucky happen to be right).  

Many factors go into the response of consumers and producers to changes in price. 

1) The degree of price change.  Many books and articles have been written about the 'tipping point' where at some price consumers and producers 'wake up' and suddenly change behavior. Thus, many who use straight line response models, are shocked at sudden and strong movements by consumers and producers. 

2) Other economic factors.  For example, if the consumers just got a pay raise, they might behave differently than if they just got fired. Thus a strengthening economy (the US currently) is a far different response than a declining economy.  

3) Technological changes.  Producers may be experiencing such a great change in technology that the costs are falling even more than anyone expects.

4) Political concerns.  At a tipping point, both consumers and producers may be influenced by other factors, such as politics, geography and personal biases.  These are near impossible to predict and can make fools of many pundits. 

Given all these factors any estimation of oil prices in 2015, such as the price as of June 30 or Dec 31 is more of a guess than a scientific estimate. My personal view is the price could fall to some very low amount, but will rebound to $70s by June and $100 by Dec. But this is a wild ass guess and any price between $20 and $150 is possible. 

Household Balance Sheets and the Economy

Everyone is wondering why the economy has been sluggish in the past couple of years. Two charts below show the dramatic changes in the household balance sheets:

First, Liabilities as a percent of Household wealth has been falling like a rock. From an all time high in 2009, they gone back to 2001 levels. This dramatic decline in household debt HAS to be recessonary.  The amount of money in the system will fall and the demand for goods will fall. 

Second, a measure of the cash-flow ability to pay debts has also fallen. If you take total household liabilities divided by disposable income, you can get a quick and dirty view of the consumer's ability to pay debt. Again this measure has fallen significantly as consumer's paid down debt. But this measure has fallen far less than the first.  Clearly asset prices are rising much faster than incomes. 

With the consumer rebalancing their assets and liabilities, the economy has suffered greatly. When will this end?  When will the balance sheets be rebalanced?  

First, demographics are a factor. With the baby boomers hitting retirement, the demand for debt must fall. The 70 year old has a much different 'desired' balance sheet than a 50 year old. To get to that 'desired' balance sheet requires liquidating debt (or not taking on debt as assets and income grow). 

Second, the next generation has high eduction debt. This high debt must be repaid and will be a huge drag on the economy for the next few years.  Most eduction debt has a relative short repayment period- 5 years vs a mortgage debt of 30 years. 

Third, even with the decline in debt usage, debt is high compared to the 1980s. The consumer balance sheet still has huge amounts of debt and especially when you look at income to service the debt. As a result it is hard to predict when the rebalancing of the consumer portfolio will be finished.

Conclusion: We have been in a slow growth mire for several years and unless incomes rise the amount of debt will continue to constrain the economy.

Nat Gas Production

Natural Gas Production

The chart above shows the 30-day average production for US Natural Gas as reported by Robry. The reason why this is important is the daily production data points have significant random day-to-day movements. These movements are temporary and confuse the trend.  Clearly we still are in an upward trend. Looking at the 2nd chart below shows the clear trend lines.

As a result, the decrease in natural gas production still has not occurred.  Yes the production is off the highs, but any measure of trends, the recent declines are well within the long-term upward trend lines.   You can quibble with the exact drawing of the lines, but it is clear the natgas production has not fallen below the long-term upward trend lines.

As a result, the people who argue natgas production is headed down are not right----yet.  Clearly production is not heading up as it was late last year.  But a slowdown in an upward trend is not a decrease in production.

Greece and Gold

Right now the price of gold has not responded to the Greek Crisis. It may not for many months, but at some point the reality of the situation is going to make gold skyrocket. Why?

1) The European voters in Greece, France and even Germany have clearly told the politicians that austerity is not an acceptable course of action. In two major elections this past weekend, we saw an overhaul in management in two European countries, France and Greece.

"In France on Sunday, Francois Hollande squeaked past his opponent to win a clear majority for president. On the same day in Greece, the conservative-leaning New Democracy party and the Left Coalition party won the largest parliamentary pluralities. What is the same in both contests is that all of the victors ran on campaigns rejecting austerity measures that they claimed had crippled their respective economies, in favor of stimulus spending. Though it is only France and Greece that held elections, there appears to have emerged a widespread demand for reconsideration throughout Western Europe of the euro zone's recovery plan. And while the winning parties in Greece scramble to emerge from chaos and form some sort of ruling coalition, Hollande is secure as president, and has become the leader of this new movement, which will likely see major changes to the unity and economic integration of Europe."

German results were also a blow against austerity: "DUESSELDORF, Germany — Voters in Germany's most populous state dealt a decisive blow to Chancellor Angela Merkel's Christian Democratic Union on Sunday, preliminary results show, a potentially ominous preview of things to come for the chancellor in next year's federal elections" The voters in every country have made it very clear they do not like austerity but they want spending.

2) How are they going to pay for these programs? Every country in the EU is already spending more than they take in revenue. The only way to pay for these programs is to print more money. Quite simply there is no alternative. Either the governments cut back expenses AND raise taxes or they print more money. They WILL print more money.

3) Right now we are in a deep recession. In addition, we are in a panic (or more accurately a flight to safety). People want their investment to be safe. As a result US Treasuries are priced at the highest (lowest yield) in 50 years. People are worried and want their money to be safe. But in a highly leveraged system as the world is in today, this need for safety will cause the economy to stay very weak. Only when people are confident in the future, will business investment, jobs and the economy pick up. Instead of recognizing this and acting the current administration took the advice of pure Keynesian economists. While the government does need to act, HOW it acts IS important. Giving $500 million to Solendra to waste will not strengthen the economy, but instead will lead to further weakness. FDR was right that Fear is the problem.

One solution to get people to move out of treasuries is to scare them with inflation. The Fed is in part trying to calm markets and make long-term investments 'cheap', but something rings false. People are still sacred and not making normal investments. The hypothesis is the FED will take more and more extreme measures to force investments out of treasuries and into the 'real' economy.

At tipping point will happen at some point and people will realize that the US Dollar, Euro and other currencies can and are being printed in unlimited amounts. Once a crisis occurs in a currency, it takes years (decades?) for a country to recover. The only question is when will we move from deflation to inflation? To that question, I have no answer. But with each QE program, the time comes closer.

Once we have a tipping point from deflation to inflation, gold prices will skyrocket. But when???

The Jobless Recovery

No matter how the government calculates the unemployment rate, the employment rate is still very very low for a recovery.
The simple fact is employment is not growing like it should in a recovery. Why?

1) Anytime you have a financial panic, the growth will be slower. This has been well documented by several studies and needs no further comment.
2) Specific actions by the Obama Administration has lead to lower employment. The health care act and government regulations in general have can lead to increased cost of employing people. Especially if the regulations deal with firing or cutting employment, firms will respond by decreasing the hiring of employees.
3) Technology has increased the productivity of employees which is a long term good for the economy, but a short term drag.
If this were true, then once economic growth increases above two percent, employment growth should pick up. If employees are very productive, it will make sense to hire them, so they increase profits. Anytime a person is more productive and the firm can increase it's sales, it will make sense to hire more people. Increases in productivity are GOOD for employment.

But as the chart below shows, employment increases just have not happened. Clearly something very basic is wrong.

Which Direction?

There are two possible extreme courses:

1) The economy grows and QE3 is not needed
2) The economy falters and QE3 is needed.

What the market seems to like is the second alternative, while I like the first alternative. What has happened every time QE3 is 'more off the table' is the market falls. But this is very shortsighted. Bernanke has made it very very very clear: The main reason for the Great Depression going longer than expected was a too quick increase in interest rates. The Fed WILL keep rates low for an extended period of time. Once economic growth returns in a reasonable rate, then and only then will the Fed take the foot off the pedal.

But the markets seem to react to every Fed meeting with uncertainty and confusion. The idea that the economy grows should be good news for the stock market. But instead, economic growth is being met with disbelief. The market is so pessimistic that the idea of sustained economic growth is discounted to the extreme. This negativity is seen through out American society today.

Even if the economy muddles through and provides low economic growth, the Fed will continue very aggressive expansionary actions. Only strong economic growth will force the Fed to act to reign in already occurring inflation.