by Roy C. Smith
Many years ago I asked the late Nobel laureate Paul Samuelson what was the most important thing he had not been able to learn about economics, and was surprised when he said “the formula for an avalanche.”
By this he meant how financial panics are triggered.
At that time, financial panics were fairly rare, though mini-bubbles occurred periodically. Today, especially after the 2007-2008 financial panic that began in mortgage-backed securities and spread to all forms of corporate securities, we are more aware of what might be called “volatility spikes.” There have been three periods since 2008 when the volatility of the US stock market exceeded 35% (it normally is about 20%), not including the month of January 2016 when the VIX only reached a high of 27%).
Volatility, the variation of returns relative to an index or benchmark, can be measured for anything that trades, including stocks, bonds, currencies and commodities such as oil, which experienced one of its sharpest volatility spikes ever over the past 18 months when prices dropped 75%.
Crude oil prices dropped by 72% in the year following the 2008 financial crisis, then the largest annual price change for oil since the Iran Revolution in 1979.
What interested Prof. Samuelson about avalanches, he said, was the sudden change from ”normal” conditions to highly abnormal ones in which everything that one knew about prices was suspended in favor of an irrational rush-for-the-exits mind set.
The Economics of Oil Prices
What we know about oil prices now is not much different from what we knew a year ago: Goldman Sachs forecasted an excess of global production over demand in 2015 of about 1.5 million barrels per day, or 1.5%. Though global economic growth was slowing, demand for oil was still increasing modestly, even after taking China’s slowdown into account. So the imbalance has been almost entirely because of supply factors. Saudi Arabia, which needs the cash but also wants to preserve its market share from encroachment by Iran, was the main reason, but US shale producers kept pumping too, apparently to avoid the cost of closing, then reopening their fields.
We also know that many new investments in exploration and oil field improvements have put on hold, which is logical when prices decline and cash is short, but as a result future production levels will decline until these investments are resumed. Thus there is a natural adjustment process built into the system that should stabilize prices over supply-demand cycles.
And, of course, the many economic benefits of lower oil prices should encourage global economic growth and future oil consumption, and therefore increase future demand.
So, how do we explain this year’s major collapse in oil prices, especially given the fact that the drop is not the result of a sudden political or economic shock that drove all the other instances of volatility spikes in oil?
Apparently the laws of economics, which would require some price adjustment but not one of 75%, seem to have been suspended in favor of a Samuleson avalanche.
You might think it is because of heightened “speculation” by hedge funds and commodities dealers. Maybe so. A 2014 IMF Working Paper by S. Beidas-Strom and Andrea Pescatori investigated the importance of speculation on oil prices and concluded that that speculation (investments by non-users of the commodity) explained between 3% and 22% of trades, a wide range but perhaps not enough to throw the whole pricing mechanism into disarray over an eighteen-month period. Speculators operate on both sides of the market, so they actually can contribute to price stability during market upheavals.
No doubt we will soon be reading about the next “Big Short,” in which some obscure oil traders made billions shorting crude oil, or stocks and derivatives tied to it. But, just as in the mortgage-backed securities market rout of eight years ago, for every seller there is a buyer who thinks the fall has gone far enough and wants to profit from a recovery. So far, these buyers (including several well known hedge funds) have lost billions. Many financed their positions on margin, which leveraged their losses or subjected them to forced sell-outs at prices set by lenders as the market deteriorated further.
Even so, since 2010 most large Wall Street banks have ended or reduced their commodities trading activities for regulatory reasons, removing their considerable buying power from the market. This has reduced the role of speculators in the oil market considerably.
In 1967 Arthur Koestler wrote an insightful book called The Ghost in the Machine that dealt with the idea that human beings still possessed DNA inherited from primitive ancestors, which could force behavior that in modern times might seem irrational or self-destructive. Koestler worried about this in the context of the nuclear age; we, however, might have to consider whether such a ghost (or maybe instead something very new) could be present in today’s trading machinery.
Of course, irrational behavior is nothing new in financial markets - indeed it’s not so irrational to sell a position because you are convinced others are selling theirs. But to the extent that such behavior can produce huge unexplained volatility spikes in basic commodities that are sustained for a year or more may be something new.
Leon Cooperman, a hedge fund guru who manages the Omega Funds, has been dealing with irrational markets for more than forty years. On January 15, he said that the turmoil in the stock market was not fully justified by underlying factors. A bit later, though, after the turmoil had further increased, he said there was something going on in the markets that he was uncomfortable with that he could not entirely explain and had made him more cautious.
What was that something?
In its January 23rd issue, The Economist had a leader entitled “Who’s Afraid of Cheap Oil?” The article pointed out that rising oil prices were bad, and falling prices were good for economic growth, but this time prices falling so far and so fast might not have been good after all. That’s because the global economy and political system may be too fragile to adjust to the price changes without immediate negative consequences that outweigh the usual positive ones.
Lower prices, the article says, have already caused a drop in new investment in the global energy industry (including coal and alternative energy sources) of about $500 billion, which will detract from global economic growth, the estimate of which recently was lowered by the World Bank to only 2.9% for 2016.
Lower oil prices are also already having a disinflationary effect on consumer prices, to the frustration of central banks seeking to revive inflation to the 2% area as an incentive for growth.
And, The Economist points out, declining prices severely impact the ability of some energy and related companies to service the considerable debt that has been added over the past few years when prices were much higher. Fears of defaults on risky debt have already pushed Emerging Market and junk bond spreads over Treasury rates to their highest levels since 2012.
Weak Suppliers and the End of OPEC
But the real ghost in the machine and oil-market game-changer is the desperate need by major producers to keep pumping despite the serious negative effects low prices impose on them. OPEC no longer is able to manage prices by curtailing production. Saudi Arabia needs cash to service its growing external debt (its current budget deficit is 12.7% of GDP), to fund its challenges to Iran in Yemen and Syria, and to keep peace at home. The Russian Ruble has collapsed along with oil prices; most of its economy, which fell by 3.8% in 2015, depends on oil and gas sales; sanctions still restrict the economy and inflation is around 15%. Venezuela, Libya, and Iraq are on the brink of economic collapse and must sell every barrel they can. Iran, with sanctions removed, wants to make up lost ground. These troubled countries together account for about 40% of world production.
The biggest buyers, who benefit the most from cheap oil, (China, India, Japan, Korea, and – still- the US) have been able to play sellers off against each other in the spot market.
And they probably still will be able to do so over the next few years as long as the political and economic instability among major producers continues.