The world falling into depression

During a deflationary depression prices go down but everythng becomes less affordable.

For now the zombies are hailing a drop in the price of petrol

Consumer Prices Plunge Most Since Dec 2008

Zero Hedge,

17 December, 2014

Great news: The prices consumers pay dropped 0.3% MoM in November - the biggest deflation since Dec 2008. Of course, The Fed will be in "considerable" panic mode at this data and may choose to crush the hope of so many that rate hikes are coming in mid-2015 as definitive evidence that the US economy is well on the road to recovery. Ex-Food-and-Energy, prices rose 1.7% YoY - slightly missing expectations of +1.8%. Of course, a big driver of this 'transitory' disinflation is a 10.5% YoY drop in Gasoline and 6.6% MoM drop in November. 

Despite this huge drop, and thge promises of various talking heads, airfares rose 1.36% in November (after also rising 2.39% in October) - so much for the benefits to the consumer.

The breakdown by component, showing the 6.6% plunge in gas prices, and the fuel oil index dropping 3.5% in November, its ninth consecutive decline.

Since everyone is most concerned by energy prices, here is what the BLS had to say:

The energy index declined for the fifth month in a row, falling 3.8 percent in November. The gasoline index continued to decrease sharply, falling 6.6 percent. (Before seasonal adjustment, gasoline prices fell 8.9 percent in November.) The fuel oil index fell 3.5 percent in November, its ninth consecutive decline. The gasoline index has fallen 10.5 percent over the last 12 months, and the fuel oil index has declined 10.1 percent. The index for natural gas also declined in November, decreasing 1.7 percent, but it has risen 3.2 percent over the last year. Electricity was the only major component index to rise in November; it increased 0.1 percent and has risen 2.8 percent over the past year.

So while gas prices dropped again, food rose, with the food index up 0.2 percent in November after increasing 0.1 percent in October.

The index for food at home rose 0.1 percent in November and has risen 3.4 percent over the past year. Indexes for major grocery store food groups were mixed in November, with three increases and three declines. The index for meats, poultry, fish, and eggs increased 0.6 percent in November after declining in October. The index for beef and veal rose 0.8 percent, its tenth consecutive increase. The index for nonalcoholic beverages rose 0.5 percent, and the index for other food at home increased 0.4 percent. In contrast, the fruits and vegetables index turned down, falling 0.7 percent in November after a 0.9 percent increase in October. The index for fresh vegetables rose 1.8 percent, but the fresh fruits index fell 2.9 percent. The indexes for dairy and related products and for cereals and bakery products both fell 0.2 percent. All six groups increased over the past 12 months, with increases ranging from 0.2 percent (cereals and bakery products) to 9.1 percent (meats, poultry, fish, and eggs.) The index for food away from home increased 0.4 percent in November, its largest increase since January 2012, and has risen 2.9 percent  over the past year.

And here is how everything else did:

The index for all items less food and energy rose 0.1 percent in November following a 0.2 percent increase in October. The shelter index rose 0.3 percent, with the rent index rising 0.3 percent and the index for owners' equivalent rent increasing 0.2 percent. The index for lodging away from home was unchanged in November. The index for medical care rose 0.4 percent in November, its largest increase since August 2013. The index for prescription drugs rose 0.6 percent, while the physicians' services index increased 0.5 percent. The airline fares index increased 1.4 percent after a 2.4 percent increase in October. The index for alcoholic beverages rose as well, increasing 0.8 percent. In contrast to these increases, the apparel index fell 1.1 percent and the index for used cars and trucks declined 1.2 percent. Several indexes posted more modest declines; the indexes for recreation, for household furnishings and operations, and for personal care all declined 0.2 percent, and the new vehicles index fell 0.1 percent. The index for all items less food and energy has risen 1.7 percent over the last 12 months. The shelter index rose 3.0 percent over that span, and the index for medical care increased 2.5 percent. Several indexes have declined over the last 12 months, including airline fares, used cars and trucks, household furnishings and operations, and recreation.

And now, back to the Fed.

The Fracturing Energy Bubble Is the New Housing Crash

Zero Hedge,

17 December, 2014

Submitted by David Stockman via Contra Corner blog,

Let’s see. Between July 2007 and January 2009, the median US residential housing price plunged from $230k to $165k or by 30%. That must have been some kind of super “tax cut”.

In fact, that brutal housing price plunge amounted to a $400 billion per year “savings” at the $1.5 trillion per year run-rate of residential housing turnover. So with all that extra money in their pockets consumers were positioned to spend-up a storm on shoes, shirts and dinners at the Red Lobster.

Except they didn’t.  And, no, it wasn’t because housing is a purported  “capital good” or that transactions are largely “financed” at upwards of 85% leverage ratios. None of those truisms changed consumer incomes or spending power per se.

Instead, what happened was the mortgage credit boom came to a thundering halt as the subprime default rates became visible. This abrupt halt to mortgage credit expansion, in turn, caused the whole chain of artificial economic activity that it had funded to rapidly evaporate.

And it was some kind of debt boom. The graph below is for all types of mortgage credit including commercial mortgages, and appropriately so. After all, the out-of-control strip mall construction during that period, for example, was owing to the unsustainable boom in home construction—especially the opening of “new communities” in the sand states by the publicly traded homebuilders trying to prove to Wall Street they were “growth machines”.

Soon Scottsdale AZ and Ft Myers FL were sprouting cookie cutter strip malls to host “new openings” for all the publicly traded specialty retail chains and restaurant concepts—–along with those lined-up in a bulging IPO pipeline. These step-children of the mortgage bubble were also held to be mighty engines of “growth”.  Jim Cramer himself said so—-he just forgot to mention what happens when the music stops.

A similar kind of credit bubble chain materialized in the hospitality segment. As the mortgage debt spiral accelerated, households began tapping their homes ATM machines through a process called cash-out finance or MEW (mortgage equity withdrawal).  At the peak of the borrowing frenzy in 2006-2007, the MEW rate was in the order of $500-$800 billion annually. Accordingly, upwards of 10% of household DPI (disposable personal income) was accounted for not by rising wages and salaries or even by more generous taxpayer financed transfer payments from Washington.

Actually, it was far easier than that.  American families just hit their home ATM cash button , and applied the proceeds to bigger, better and longer vacations, among other things. Soon, hotel and vacation resort “revpar”  (revenue per available room) was soaring owing to surging occupancy and higher room rates.

On the margin of course, the incremental demand that sent hotel revpar soaring was derived from mortgage credit confected out of thin air by the financial system. Yet in the short-run is was a strong signal for more investment in hotel rooms and that’s exactly what materialized.

As it happened, of course, the revpar surge was a false signal and the hotel room building spree was a giant malinvestment. Construction spending on new hotels exploded from $10 billion to $40 billion annually during the 70 months after early 2003. Except….except that when  the mortgage boom stopped and the frenzied MEW extraction halted, revpar plunged and the hotel room construction boom retraced back below the starting line in barely 20 months.

In all, between Q4 2000 and Q4 2007, US mortgage credit expanded by the staggering sum of $8 trillion. “Staggering” is not hyperbole. The growth of mortgage debt outstanding during that 84 month period exceeded by nearly 20% all of the mortgage debt that existed at the turn of the century.  The CAGR for that period was 12% annually or orders of magnitude higher than the sustainable growth capacity of output and incomes. So mortgage credit went from 65% of GDP to 100% in an historical flash.

The tsunami of mortgage credit exceeded anything previously imaginable by even the most egregious “easy money” populists. But here’s the preposterous part. The monetary politburo watched this tidal wave rising and did not become alarmed in the slightest. Indeed, Greenspan and Bernanke thought MEW was a wonderful tool to goose household spending and thereby justify its spurious belief that a handful of central bankers could deftly guide the $14 trillion US economy to the nirvana of permanent full employment prosperity.

The above parabolic curve by no means represents the free market at work. For that kind of borrowing explosion to occur without causing interest rates to soar sky-high (and thereby soon choke off the borrowing spree), there would need to have occurred a powerful upsurge in the US savings rate, permitting the market to clear at prevailing interest rates.

It does not take much deep historical research to remind that didn’t happen. Not in the slightest. Indeed, the US household savings rate had been sinking ever since the Greenspan money printing regime got off the ground in response to the 25% stock market crash in October 1987. And once the Maestro went all-in opening up the monetary spigots in January 2001, thereby driving money market rates from 6% to 1% during the next 30 months, household savings resumed their tumble into the sub-basement of history.

As shown below, by the peak of the mortgage boom when demand for savings was at high tide, the savings rate had actually vanished, reaching hardly 2.5% of personal income. That compared to pre-Greenspan rates of 10-12.5% (based on current NIPA measurement concepts), meaning that the US economy was parched of savings at the very time it was bursting with new mortgage debt issuance.

Stated differently, the mortgage credit boom exploded uncontrollably in the run-up to the financial crisis because free market pricing of debt and savings had been totally distorted and falsified by the monetary central planners at the Fed. The resulting $8 trillion eruption of mortgage credit, in turn, funded bubble style spending and investment throughout the warp and woof of the US economy—–setting the stage for the subsequent painful liquidation and reversal.

The housing bubble and bust, in fact, was a dramatic if painful lesson on the danger of central bank generated financial repression. Drastic mispricing of savings and mortgage debt in this instance touched off a cascade of distortions in spending and investment that did immense harm to the main street economy because they induced unsustainable economic bubbles to accompany the financial one.

The boom and bust of residential construction and the related whip-sawing of employment and supplier industry production is obvious enough.  But the violent surge and plunge pictured below is not some unique artifact of a once-in-100-years housing anomaly. Instead, it was a predictable and generalizable effect of central bank driven mispricing of debt and equity capital and the availability of vast gobs of fiat credit.

The only way to describe the above happening is that it represents the violent liquidation of bubble economics. After doubling between mid-2000 and mid-2006 owing to the home price and mortgage bubble,  residential construction spending plunged by 65% during the next 36 months. That was not exactly Bernanke’s “Great Moderation” so insouciantly pronounced in March 2004—hardly 24 months before the above cliff dive commenced.

And its not a matter purely for future study by the Princeton economics department, either. As President Obama would be wont to say, “some folks” got hurt along the way. In fact, nearly 50% of all employees in residential construction at the 2006 peak were out of work a few years after the bus.

Substitute the term “E&P expense” in the shale patch for “housing” investment and employment in the sand states, and you have tomorrow’s graphs—–that is, the plunging chart points which are latent even now in the crude oil price bust.  But the full story of the housing bust also reminds that the long caravans of pick-up trucks which will soon be streaming out of the Bakken in North Dakota will represent only the first round impact.

The real problem with central bank financial repression is that it plants financial land-mines in hidden places throughout the financial system and real economy. Indeed, the one thing that the Keynesian money printers are correct about is that a “multiplier” effect is actually operative. That is, the chain of distortions which results from the mispricing of capital and the ballooning of fiat credit multiplies many times over as it cascades through the economic system.

So that is why its important at this juncture to review the Maestro’s favorite chart during the housing boom. During the better part of three years more than one-half trillion dollars per year entered the household spending stream right out of home equity piggybanks. By some estimates the peak rate was nearly $800 billion annualized or, as indicated above, upwards of 10% of total disposable income.

Needless to say, this artificial spending boom washed through the length and breadth of the US economy, generating sales of Coach handbags, pilates equipment, big screen TVs, time-share resort units and countless more that would otherwise not have happened. So when the air came out of the mortgage debt bubble, real PCE dropped for 20 straights months—–unlike anything previously experienced in the post-war era.

But as shown below, that was not due to some mysterious disappearance of Keynesian “aggregate demand”. Consumption spending faltered because America’s home ATM’s went dark.

Here’s the point. In an honest free market for debt and capital there would have been no MEW eruption in the first place. The incipient boom in mortgage credit would have throttled itself. That is, had the Fed not had its big fat thumb on the price of debt, interest rates would have soared, and American households would have been incented to add cash to their nest eggs, not strip mine the equity from their homes.

And that leads exactly to the next bubble——the energy boom that is now hitting the wall. The trillions of MEW that US households falsely extracted from the inflated equity value of their homes did not stay within the confines of a closed model US economy. Instead, over the decade or so before the financial crisis a goodly portion flowed into demand for shirts, shoes, electronics and other gadgets from Mr. Deng’s export factories in East China.

And during that debt-fueled US consumption boom, interest rates did not remain low because the workers in China’s new sweatshops had an outsized appetite for savings, as per the sophistry spewed out by Greenspan and Bernanke. No, it was the People’s Printing Press of China that had an humongous appetite—–that is, for mercantilist economic growth obtained by pegging their exchange rates at artificially low levels in order to keep their export factories booming.

So countering the Fed’s fat thumb on the domestic cost of debt in the US, the PBOC keep its thumb on the RMB exchange rate, thereby flooding its domestic economy with the most fantastic expansion of credit fueled investment in industrial capacity and internal infrastructure that the world had ever seen. 

Between 2000 and 2014, China’s credit outstanding soared from $1 trillion to $25 trillion. Consequently, its credit swollen GDP expanded from $1 trillion to $9 trillion in a comparative heartbeat; and its crude oil consumption soared from 2 million barrels per day to 8 million.

In short, the Fed exported bubble finance to the entire world, but most especially China and the EM. The upshot was an extended era of booming but phony global growth, and a consequent artificially high oil prices at $115 per barrel.

When central bank inflated oil prices were coupled with lunatic junk bond yields in the US shale patch at barely 300 bps over the central bank repressed yield on the US treasury note, the result was the same old bubble thing. Namely, a half trillion dollar flow of high yield bonds and loans to the energy sector, and a wholly artificial explosion of US shale liquids production from 1 million to more than 4 million barrels per day.

Like in the case of the housing bubble, the energy boom was an accident waiting to happen— testimony to another even grander experiment by the madmen running the world’s central banks.  It is now exploding right on schedule. The plunging graphs subsequent to the housing bust are now being re-gifted to the energy patch and all the bloated, unstable chains of finance and real economic activity which flow from it.

The graph below which shows that every net job created in the US during the last seven years is attributable to the shale states will be one of the first to morph into a less happy shape.

But there is something else even more significant. The global oil price collapse now unfolding is not putting a single dime into the pockets of American households - the CNBC talking heads to the contrary notwithstanding.  What is happening is the vast flood of mispriced debt and capital, which flowed into the energy sector owning to the Fed’s lunatic ZIRP and QE policies, is now rapidly deflating.

That will reduce bubble spending and investment, not add to economic growth. It’s the housing bust all over again.

Mortgage Applications Tumble As Citi Warns Oil-Drop Risks Housing/Jobs Slump

Zero Hedge,

17 December, 2014

Mortgage applications for home purchases fell almost 7% last week, fading recent gains and hovering once again back at 20 year-lows (entirely unable to reflect the housing 'recovery' for the average joe). The plunge in applications comes as mortgage rates crash back to 4% - the lowest in 19 months. The reason - apart from unaffordability - is explained by Citi's Will Randow who notes the spillover effects of the "unequivocally good for everyone" drop in oil prices has a dramatic effect on both jobs (prolonged price drop means a loss of ~200k jobs) and housing (starts expected to drop 100k if oil prices remain low). Maybe talking-heads should reconsider that "unequivocally good" narrative.

Mortgage applications tumble back near 20-year lows...

And Architect activity is plunging...

Even as Mortgage rates near record lows...

*  *  *

As Citi explains, the drop in oil could be responsible for the apparent lack of demand...

The upstream oil & gas industry (i.e. extraction, support activities for operations, and related machinery manufacturing) has added roughly ~0.2M jobs since nonfarm payrolls bottomed in July 2010 (TTM avg), which represents 16% of goods producing jobs added and 2% of total jobs added since then. Assuming a prolonged decline in oil prices below $60 per barrel causes the ~0.2M jobs added to cease, our sensitivity analysis leads us to believe that ~0.1M cumulative US Housing Starts are potentially at risk, factoring in that ~0.2M jobs are eliminated at the current ~1.7 jobs per US household ratio.

Among US homebuilder end-markets, Houston and other parts of Texas appear to have the largest potential risk associated with lower oil prices and related job losses. The last time oil prices sustained (current dollar) price levels below $60 per barrel, annual TX housing permits bottomed at ~40K homes (TTM) versus ~160K homes in October 2014 (TTM), but did eventually recover, even at sustained lower oil price levels. So, similarly, it appears downside risk is near ~0.1M in incremental lost Housing Starts, predominantly in Texas.

Charts: Bloomberg

"Oil May Drop To $25 On Chinese Demand Plunge, Supply Glut, Ageing Boomers"

Zero Hedge,

17 December, 2014

By Paul Hodges of International eChem via Russell Napier's ERIC

We have forecast since mid-August that Brent oil prices would fall to “$70/bbl and probably lower”, and the US$ would see a strong rise. As Chart 1 shows, Brent has now reached our target, falling 40%, whilst the US$ has risen 10%. We believe this represents the first stage of the Great Unwinding of policymaker stimulus that has dominated markets since 2009. This Note now takes our oil price forecast forward into H1 2015

Astonishingly, most commentators remain in a state of denial about the enormity of the price fall underway. Some, failing to understand the powerful forces now unleashed, even believe prices may quickly recover. Our view is that oil prices are likely to continue falling to $50/bbl and probably lower in H1 2015, in the absence of OPEC cutbacks or other supply disruption. Critically, China’s slowdown under President Xi’s New Normal economic policy means its demand growth will be a fraction of that seen in the past.

This will create a demand shock equivalent to the supply shock seen in 1973 during the Arab oil boycott. Then the strength of BabyBoomer demand, at a time of weak supply growth, led to a dramatic increase in inflation. By contrast, today's ageing Boomers mean that demand is weakening at a time when the world faces an energy supply glut. This will effectively reverse the 1973 position and lead to the arrival of a deflationary mindset.

CONTENTS Page:

1. Oil prices continue bouncing down the stairs to lower levels. Page 2
2. Financial players have destroyed price discovery in oil markets.  Page 4
3. OPEC’s high prices have accelerated move away from oil to gas. Page 5
4. Gulf countries risk losing US defence shield if oil prices stay high. Page 7

1. Oil prices continue bouncing down the stairs to lower levels

Chart 2: Brent prices are now in a steep downtrend

Brent oil prices have reached the “$70/bbl and probably lower” level that we forecast in August. So we now need to think about where they go next. Luckily, Chart 2 above can still guide us, as it has done since September 2010. We first forecast the collapse on 18 August, and then followed this on 27 August with a detailed analysis and specific price forecast:

“How low will prices go? We can have no idea, as prices have never been this high for so long. Nor can we rule out a further massive stimulus effort by the central banks at some point. But "technical trading" logic would suggest they will fall to at least the 200-day exponential moving average, currently around $70/bbl, and probably lower (red line)”.

Unfortunately, conventional wisdom completely missed this move, believing that prices would always stay at $100/bbl. Many companies and investors have lost large amounts of money as a result of wearing these rose-tinted glasses.

WHAT HAPPENS NEXT?

There are 2 parts to the question of ’What Happens Next?’:

• Why is this happening?
• will tell us when the price move is ending?

The “Why” question is easy to answer:

• China’s stimulus policy has ended. Instead, President Xi is moving to his New Normal concept. He intends to improve income levels for ordinary people, not to create wealth effects for a minority via a property bubble
• The US Federal Reserve’s Quantitative Easing (QE) policy has paused. Many investors are preparing to ‘dash for the exits’ just before interest rates rise, as they know prices for financial assets are well out of line with fundamentals

This means that the stimulus policies that pumped air into China’ s demand bubble and the US financial asset bubble have stopped pumping. And a child knows what happens to bubbles when you stop pumping more air – they deflate very quickly. The initial catalyst for this was the unwinding of China’s ‘collateral trade’. As we warned in June, this is now opening the fault lines in the debt-fuelled ‘ring of fire’ created by central bank stimulus.

The “What” question relies on the chart for an answer. We are still in the Great Unwinding phase of these stimulus policies, so we cannot yet rely on supply/demand fundamentals to guide us. Instead, as the chart shows:

• The ‘triangle shape’ extended for 5 years before prices finally fell (red, green lines)
• Prices then collapsed rapidly through support at $90/bbl and $70/bbl (purple)
• $70/bbl was also the 200-day exponential moving average price (red)
• Our August forecast has thus been realised, and prices have indeed carried on falling

We are now in a classic falling formation, bounded by the blue line. We think of this as a rubber ball bouncing down stairs. The ball falls off one stair, bounces to the next, and never quite manages to bounce back to the higher stair. Then it bounces down to the next stair, before eventually reaching the bottom.

Market traders instead call this a “Lower highs, Lower lows” pattern, where sellers continue to dominate. Buyers appear at the lows, but then give up as more sellers appear and sell into the rally. So we will only know when the selling is finished when the price finally makes a ”Higher high” again, and bounces back onto the stair above.

In terms of supply/demand fundamentals, however, little has so far changed. There have been no major production cutbacks or demand increases. As expected, Saudi Oil Minister Ali al-Naimi, wants the market to decide, saying Wednesday, ”Why should we cut production? Why?”. Equally, many developing countries have been busy removing subsidies that supported demand.

It is therefore hard to see what will stop prices continuing to fall towards $50/bbl in H1.

CHINA WILL AGAIN BE KEY TO THE NEXT MOVE

What happens then will be the key question. Geopolitical disruption cannot be ruled out. Russia, for example, might cut gas supplies to try and boost energy prices. But otherwise, the key to the future will continue to be China.

Asian producers and traders now have large inventories of almost every oil-related product. Buyers have simply stopped buying in recent weeks as prices have collapsed. So the question is whether China’s demand will now increase in January, before markets close for Lunar New Year in mid-February. A lot of money is now riding on this issue.

If these hopes prove false, and the West enjoys a mild winter, there would seem little to stop prices heading back towards historical levels of $30/bbl – $40/bbl. This would be good news long-term, as $30/bbl is an ‘affordable’ price for the global economy, at 2.5% of GDP. But it would be very bad news for investments based on the two myths that (a) oil will remain at $100/bbl forever and (b) China’s demand will increase exponentially as it becomes middle-class. Equally important is that a sustained price fall will mean deflation becomes inevitable in the Eurozone and Japan, irrespective of any further QE initiatives.

Financial markets will also be impacted as a new ‘Minsky moment’ develops, and investors suddenly realise, as in 2008, that they have overpaid for their assets and rush for the exit.

The International Energy Agency’s December Report suggests OECD stocks “may bump against storage capacity limits” in H1, and confirms our own fears that we risk “social instability or financial difficulties” in H1. This highlights why we have long feared the Great Unwinding will be a very bumpy road, as we described back in June.

2. Financial players have destroyed price discovery in oil market

Chart 3: Volumes in financial futures markets is now many times physical production.

Oil prices should be set by the balance of supply and demand. But as Chart 3 shows, oil markets have instead become dominated by financial players, as pension and hedge funds decided to buy oil as a “store of value“.

Before 2000, financial market volume (red line) had equalled annual oil production (green). This worked well, providing physical players with sufficient liquidity to enable price hedging to take place. But in 2000, after the dot-com crash, central banks stopped focusing on the need to defend the value of the currency – previously their main role. Instead, they refocused on trying to maintain economic growth. And they began to use their new weapon created in the dot-com revolution, the power to print ‘electronic money’.

OIL MARKETS LOST THE POWER OF PRICE DТSCOVERY

Chart 3 shows how this has played out. Unfortunately for all of us, central banks couldn’t resist the temptation to play with their new toy. They came to believe it had near-magical powers, and could control the economic cycle. After the Crisis began in 2008, they even gave it a new name “Quantitative Easing” (QE). And central banks around the world began to use it to print trillions of dollars. Unsurprisingly, of course, this had side-effects.

One was that US pension and hedge funds quickly realised that QE would also devalue the US$. They therefore rushed to invest in oil markets as a supposed ’store of value‘.

What they didn’t realise was that this created a massive imbalance of financial versus physical market demand. Producers couldn’t suddenly double their production at the touch of an electronic button. Financial sector demand simply overwhelmed physical supply:

• Hurricane Katrina in 2005 had already shown the potential for this type of speculation to occur.
• By the time US refineries were operating again after it, financial trading was 4x physical production.
• By 2011, with the support from QE, financial players were trading the equivalent of 6x physical production.

Thus financial market demand came to dominate physical demand, and prices leapt skywards (blue line). The physical market’s key role, that of price discovery, was destroyed [ZH: same as the gold market, incidentally]

Many analysts failed to make the linkages, and instead claimed these high prices were justified by reduced supply or increasing demand. But as we know today, there has never been any physical shortage of oil since the Crisis began.Instead, what is now becoming obvious is that the collapse of the price discovery process led producers to over-invest and create an energy glut.

There are two key issues that will now determine future prices:

• One is that gas has been increasing its market share at oil’s expense.
• The second is Saudi Arabia’s need to ensure the 1945 US/Saudi ‘oil-for-defence agreement’ continues.

We are in for a very bumpy ride, as oil prices return to being based on their own supply/demand fundamentals.

3. OPEC’s high prices have accelerated move away from oil to gas

Does OPEC have a future? Or has it already disappeared as an effective force in oil markets? We are not alone in asking this question. Saudi Oil Minister Ali al-Naimi asked the same question in the summer, suggesting OPEC Ministers should instead meet once a year, and have occasional videoconferences, adding:

“We don’t need a meeting. People come and make nice when at the end of the day, Saudi Arabia carries the burden of balancing the oil market.”

Recent events have shown Naimi meant what he said. He understands that major oil producers need to monetise their product quickly, as it is likely much of today’s vast reserves will end up being left in the ground. This has already happened with coal, after all.

Nobody today worries about the potential for coal shortages set out in the Club of Rome’s famous 1972 Report, ‘The Limits of Growth’ . And the chart above, based on BP data, suggests oil will likely share coal’s fate:

• Consumption of oil (red line) and gas (blue) grew at similar rates from 1965-75
• Both gained market share versus coal in relation to total energy demand (green)
• But OPEC’s high oil prices from 1973-1985 gave a sustained boost to gas demand
• Record oil prices since 2005 have further boosted gas and reduced oil consumption
• They have also reduced OPEC’s oil market share to 42% today versus 51% in 1974

Chart 5: Energy markets are now transitioning from oil to gas.

Chart 5 from ExxonMobil’s 2013 ‘Outlook for Energy to 2040? places these trends in a longer-term context.

- Wood (brown) was the major fuel 200 years ago, but was replaced by coal (orange)

- Oil (green) has since replaced coal, but it is now being replaced by gas (red)

- In 50 years, gas may be replaced by renewables, hydro-electric or nuclear as a fuel

So OPEC faces a future where its product, oil, is now inevitably losing market share to gas. It made a terrible mistake by allowing prices to rise to unaffordable levels in 1974-1985. And since 2005, it has repeated the same mistake.

Energy users have choices, after all. Many have chosen to abandon oil for gas or other fuels. Those tied to oil have reduced consumption by improving energy efficiency.

Even the US has finally moved to adopt European fuel efficiency standards for its auto fleet. Since 1980, US passenger car fuel economy has risen 27%, from 26 mpg to 33 mpg. And this trend is accelerating as today’s more efficient cars replace older models. The standard for new vehicles will be 35.5 mpg (15.09 km/l) in 2016.

Equally important is that most OPEC countries have undermined the oil quota system:

- They have built large numbers of oil-based refineries, as well as oil/gas-based petrochemical complexes

- Those using oil effectively increase the country’s oil exports beyond its official quota

- Those using gas increase its total energy exports, effectively cannibalising oil’s share of the energy market

Naimi has another reason for abandoning OPEC today, namely the growing geopolitical threat to Saudi and the other Gulf Co-Operation Council (GCC) countries. The GCC are surrounded by potential enemies, all of whom would like a share of its current oil wealth.

In these circumstances, they cannot possibly continue to allow high prices to destroy the rationale for the US defence shield on which they have depended since 1945.

4. Gulf countries risk losing US defence shield if oil prices stay high

Chart 6: Canada now exports more to the US than OPEC

A version of Chart 6 must have been keeping ministers awake at nights in Riyadh and other Gulf Co-Operation Countries (GCC) in recent months. “How did we allow Canada to supply more oil than OPEC to the US?” they worry. ”What did we think we were doing?”

This might not be quite so critical if the GCC was able to defend itself militarily against its enemies. But Saudi Arabia, the main GCC country, has a population of just 27 million. The total population of the other GCC countries is just 23m. And they all remember very well what happened in 1990, when OPEC-member Iraq decided to invade GCC-member, Kuwait.

It wasn’t Nigeria, or Venezuela or Libya or another OPEC member that came to their rescue then. It was the USA, under the long-standing 1945 oil-for-defence deal agreed by President Roosevelt and King Saud. Roosevelt had needed Saudi oil to rebuild the US after World War II, and Saud needed someone to fight off his enemies.

Now, fast forward to today. Can one imagine President Obama and Congress putting US armies into a modern-day Operation Desert Shield/Desert Storm? Or UK Prime Minister Cameron rushing to persuade the President to do this? Of course not. But Margaret Thatcher did in August 1990, telling President Bush “This is no time to go wobbly”. And Congress agreed, as we all knew we needed friendly regimes in Riyadh and the GCC.

Chart 7: GCC exports to the US are falling as Canada’s increase

The second chart highlights the key message. Of course, it wasn’t OPEC’s fault that oil prices went back to record levels over the past decade, as discussed in section 2. But they allowed it to continue, instead of increasing supply post-2008, and collapsing the whole charade. Sadly, they preferred to believe the story that the world could now live with $100/bbl oil - though it had never done so before, and they forgot that high prices encourage new supply:

• GCC oil exports to the US had historically been on a rising trend (purple line)
• But their volume peaked at 2.5mbd after 2004, and now risks falling below 1.5mbd
• Canadian imports have instead been rising from 1mbd in 1993 to 3.5mbd today (red)
• And Canadian volumes are continuing to rise, whilst GCC volumes fall

So what would happen today if the Caliphate or someone else decided to attack? After all, the GCC countries are immensely wealthy after a decade of high prices. Would the US, UK and other countries come to their rescue again?

The GCC countries have clearly woken up to this critical issue, that their position is extremely vulnerable without US support. This have suddenly begun to plan their own oil price strategy, independently of OPEC. Instead of agreeing to production cuts, Saudi Oil Minister Naimi has said that in future, “the market sets the price”.

* * *

Prices have so far fallen $40/bbl from $105/bbl since we first argued in mid-August that a Great Unwinding was now underway. And there have been no production cutbacks around the world in response, or sudden jumps in demand. 

So prices may well need to fall the same amount again, before GCC leaders can once again sleep easily in their beds at night.