FRACTIONAL FLOW

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The Price of Oil

Crude oil is the world’s biggest and most important traded commodity.

Figure 1: The chart shows the oil price (Brent) with some policies/decisions/events. The monetary and fiscal policies of the world’s largest economies, China [red text boxes] and the US [yellow text boxes] and supply events/policies [grey text boxes]. The red line shows the annual moving average of the oil price.

In some earlier articles, like this and this, I explored for relations between the oil price, the world’s credit creation and interest rates.

This is a continuation of my exploration of how the world’s credit creation affects the structural level of the oil price.

I found it now right to repeat one of my formulations from back in 2015:

  • Any forecasts of oil (and gas) demand/supplies and oil price trajectories are NOT very helpful if they do not incorporate forecasts for changes to total world credit/debt, interest rates and developments to consumers’/societies’ affordability.

As time passes more is learned and more data becomes available which in theory should help improve both the understandings and the sights.

This article presents results from applying statistical analysis (with data spanning more than 15 years) for any relations from developments in total credit/debt from the non financial sectors in 43 countries (in 2017 representing more than 90% of the worlds’s GDP) with data from the Bank for International Settlements (BIS) to changes in the oil price, refer also “Some assumptions, terms and acronyms used in the article” at the bottom.

Developments in total credit/debt is very much related to developments in interest rates, primarily the US Federal Reserve Bank’s (FRB) funds rate (as the US dollar is the world’s dominant reserve currency) which now is expected to be set higher, the London Inter Bank Offered Rate (LIBOR) and the US Treasuries 10 Years rate. A keen eye should also be kept on developments on the now flattening yield curve and exchange rate fluctuations.

It is also important to make good assessments about the abilities to the various balance sheets to take on and service more debt. This helps monitor developments in consumers’ affordability which forms the demand side of the equation.

  • The structural oil price is formulated from the interactions of fiscal and monetary policies and supply events/policies.
  • The oil price has shown and will continue to show wide fluctuations. It is the monetary and fiscal policies that give the dominant structural support for demand and thus the oil price (defines the price movements).
  • Suppliers have little control on demand, but could resort to supply policies to support a price floor.
    The price collapse in 2014 was a result of strong growth in supplies, primarily led by debt fueled US Light Tight Oil (LTO) extraction.
  • The strengthening of the US$ (oil is priced in US$) has now resulted in very high oil prices in local currencies, refer also table 1.
  • Broadly speaking, it now appears that the world’s non financial sector needs to add $8 – $10 Trillion annually in credit/debt to support growth in the oil price, refer also figure 8.
    Estimates based on data from the Institute of International Finance (IIF) and BIS show that in Q1 2018 the world’s total non financial debt was $188 Trillion with another $61 Trillion in the financial corporations, totaling $249 Trillion.
  • Since 2000 there has been 3 distinct credit/debt cycles for the 43 (refer also figure 7 and 8).
    The first ended in mid 2008 with the Global Financial Crisis (GFC) (duration about 7 years).
    The second ended with the collapse in the oil price in mid 2014 (duration about 5 years).
    The third started about mid 2015 and, as of writing, could be entering its fourth year.
  • The analysis found strongest correlation (above 0,72) between changes to the 43s total private and public credit/debt creation and changes in the oil price at a time lag of 3 months, refer also figure 10.
    • Why this matters? If the world’s credit/debt growth supports the oil price, a slowdown or reversal of the world’s credit/debt creation (deleveraging) should be expected to affect the oil (and energy) prices negatively.
      The results of the statistical analysis show there is an expected time lag of about 3 months from major changes in the world’s credit creation (leading indicator) to changes in the oil price. The correlations were strong with a time lag of 0 – 6 months from changes in the credit creation to changes in the oil price.
      The supply surplus starting in 2014, which collapsed the oil price, appears to be the driver for a period with lower credit creation, which suggest that the lowered oil price temporarily lowered the world’s demand for credit.
  • Changes in credit creation are the strong leading driver of changes in the oil price.
  • A simple illustration of the perspectives of the relations of the oil price, interest rate and total debt is now to look at how much the oil price has to grow to have similar effects on the world economy as an increase in the interest rate of 0,25% on the worlds’ total debt of about $250 Trillion, which continues to grow.
    An increase of the interest rate of 0,25 % adds $625 Billion to the world’s annual debt service costs. The world now consumes about 30 Gbo/a (crude oil and condensate) which means that an increase in the oil price of $20/bo has about similar effects on the world economy as an interest rate hike of 0,25%. Some major central banks, led by FRB, now plan for more interest hikes and Quantitative Tightening (QT) in the near future.
  • The above serves as a powerful illustration of the growing competition for how the consumers’ available funds will be prioritized between servicing growing debts or supporting a higher oil price.
    Historically, precedence was given to debt service and consumers reduced other (including oil) consumption.

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Written by Rune Likvern

Tuesday, 21 August, 2018 at 14:34

The Powers of Fossil Fuels, an Update with Data per 2017

This post is an update and small expansion of The Powers of Fossil Fuels spanning more than two centuries of the history of the world’s energy, primarily fossil fuels (FF), consumption.

  • Between 2002 and 2017 world energy consumption grew with about 39%, world Gross Domestic Product (GDP) by 130% and world total debts by more than 160% (market value and expressed in US dollars).
  • The narrative of the growth story of the world economy (GDP) appears as a rule to leave out two participants:
    1. DEBT and the accelerating debt growth since the 1980’s, more notably since the start of this millennium and how this unprecedented growth in total world debt helped pull forward ENERGY demand.
      Post the Global Financial Crisis (GFC in 2008/2009) the continuity of economic growth became facilitated by concerted policies by the world’s major central banks by their low interest policies and Quantitative Easings (QE).
      Lower interest rates allowed room for more DEBT on most balance sheets and growth in total DEBT is important for continued economic growth.
    2. ENERGY (and primarily FFs) consumption and its strong growth facilitated by the rapid growth in DEBT.
  • Simplistic explained is GDP a monetary measure of the annual volume of transactions.
    These transactions involve the exchange of products and services which require some input of ENERGY and in recent years growing amounts of DEBT allowed for this to happen.
    This illustrates that money/currency is a claim on ENERGY.
    The orderly retirement of the growing DEBT is a claim on future ENERGY.
  • This post also takes a brief look at the recent years’ growth in solar and wind (renewables, RE) and how their growth measured up against FFs since 1990 and Year over Year (YoY) changes for FF and RE since 2000.

Figure 1: The chart shows the developments in total world energy consumption split on sources as of 1800 and per 2017.
Energy sources are stacked according to when these were introduced into the world’s energy mixture.
The black line (plotted versus the left hand scale) shows development in the world’s GDP in current US dollars since 1980 based on data from the International Monetary Fund (IMF).

In the early 1800s biomasses (primarily wood) were humans’ primary source for exogenous energy. Coal was gradually introduced into the energy mixture after the successful development and deployment of the steam engine which gave birth to the Industrial Revolution. Coal is a nonrenewable, abundant and a denser energy source than wood.

The growing use of biomasses had led to deforestation in those areas serving energy intensive industries like mining and metals.

The steam engine and its use of abundant coal as an energy source made it possible to rapidly expand the industrial production, create economic growth and thus the Industrial Revolution was made possible by fossil fuels.

With the most recent discoveries and introduction of fossil oil and natural gas there appeared to be several abundant sources of volumetric dense energy that could entertain exponential debt fueled economic growth.

Fossil fuels represent natures’ legacy stock of dense energy (ancient sunlight) that during some decades has been subject to an accelerated depletion.

Several reports in the media may now leave the impression that we are at the threshold for a smooth transition from FFs to RE (solar and wind).

How does this measure up against hard data for RE (solar and wind) versus FFs?

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Oil, Interest Rates and Debt

At first glance it is hard to see how oil, interest rates and debt are connected. Two of them are human constructs while oil (fossil sunlight), a gift from Mother Nature, took tens of millions of years to process. Oil is an endowment extracted from a confined underground stock and is now the most dense and versatile energy source known to man.

Figure 1: Chart that shows the development of [extraction] cost of oil and interest rates (US 10 Year Treasuries) has developed since 2000 and a likely trajectory for oil extraction costs.

Figure 1: Chart that shows the development of [extraction] cost of oil and interest rates (US 10 Year Treasuries) has developed since 2000 and a likely trajectory for oil extraction costs.

Both lines are SIGNALS, and most likely plan their future based on only one of them.

The 10 Year Treasury (or similar) rate is the reference used for amongst other things to set interest rate for mortgages. Most now, aware of it or not, base their future plans on the expectations to developments of the 10 Year Treasury.

What is now playing out in the oil market may be described as below;

Low interest rates [stimulates debt growth] => Pulls demand forward => Oversupply => Deflation

How will the interest rate develop in the future?

This is important as the present huge global debt overhang weighs heavily in the consumers’ balance sheets and their affordability for costlier oil. It is also important for oil companies’ long term planning to bring costlier oil to the market.

A lasting, low rate makes higher debt loads manageable. Interest rates works both sides of the demand/supply equation.

A higher interest rate will have serious implications for highly leveraged consumers and oil companies.

The dynamics may be described as below:

Higher interest rate => lowers demand => downward pressure on price [deflation] => makes it harder for [highly leveraged] consumers/oil companies to service their debt overhang => lowers investments to develop costlier supplies

At some point in time the present oil supply overhang will come to an end. This will become reflected in a higher price.

The timing of these events creates uncertainties and the agile and financial strong oil companies will sweat out a lasting low oil price.

Few are aware of that the costs of accessing our real capital (like oil) that runs our economies are rapidly increasing.

What is different this time is that the oil price may remain lower for longer than the estimated full cycle break even costs for new developments.

The suggested path for costs is believed in the near term to come down as oil service companies have reduced their prices to shoulder the burden from the recent price collapse. Over time, the capacities of the service companies will become aligned with the demand for their services and products. At some point, as the oil price recovers and investments pick up, the market mechanisms will bring the prices from the service companies up as the service companies also need to make a profit to stay in business.

In figures 4 and 5 are shown how the combination of lower interest rates and a lasting, high oil price encouraged the oil companies to rapidly take on more debt to develop costlier oil on the expectations that consumers had remaining ability to take on more debt/credit to pay for this, thus allowing the oil companies to retire their debts.

The oil companies’ behavior in the recent decade is reminiscent of group think. Few expected the oil price to collapse, though the oil industry itself repeatedly point out the cyclical nature of the oil price.

The aggregate of developments (primarily driven by an amazing growth in the extraction of light tight oil [LTO]) gradually resulted in a supply overhang that made the oil price collapse.

The costs of extracting real capital, like oil, has been rapidly increasing, yet we are making decisions for the future as if it were decreasing, based on the price of capital (money). This is a short term phenomenon that will last until supply and demand become balanced.

The present situation with an apparent oil glut and low prices is a temporary false signal.

This may also be the case with the low interest rates.

The near future will reveal how the competition for available funds to service a still growing huge global debt overhang fare towards the need to fund developments of costlier oil.

Can an increasingly leveraged global economy handle both higher oil prices and interest rates and still remain on its growth trajectory?

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