What Do Oil Prices Signal?

November 14 2018

The U.S. midterm elections are done. The Democrats gained a majority in the House of Representatives, whereas the Republicans gained a majority in the Senate. This implies that Trump will have more trouble in introducing new legislation (another tax hike will be close to impossible, for instance), but will probably make it to the end of his term. Moreover, Trump can quite easily propose new Federal Reserve board members and Supreme Court judges; whereas Trump can propose candidates to fill vacant positions, they must later be confirmed by the (Republican-colored) Senate. It remains to be seen how many trade tariffs Trump can justify without passing them through Congress, through executive orders, but he might have some discretional power to impose, especially upon China, additional tariffs. This summarizes roughly the political outlook for the coming two years, but this week the rapid decline in oil prices are perhaps more notable. Oil prices have collapsed to approximately twenty percent below its recent highs and are now in a bear market. What are oil prices signaling?

Oil Prices Fall: Oil Demand Is Waning?

In a bizarre and never-seen losing streak, oil prices declined for the twelfth day in a row. The price of WTI oil dropped to $55 per barrel, whereas Brent oil (the global benchmark) fell back to $65 a barrel.

But why are oil prices suddenly collapsing? The motives must be sought, especially, on the demand side. It appears that the global economy is not as strong as many pretend. Both OPEC and the IEA adjusted the growth in crude oil demand for the coming years downward. And it is generally known that both organizations are extremely cautious and reluctant to radically alter forecasts: the oil demand could easily be further adjusted downward for a couple of times.

Some are even speculating about “peak oil demand”; the highest point crude oil demand will ever reach, measured in barrels per day, beyond which oil demand will merely decline, especially due to innovations and new alternatives for fossil fuels.

The (historically) large price gap between, on the one hand, WTI oil and, on the other hand, Brent oil is especially interesting. It is a simple consequence of the shale oil boom in the United States, driven by fracking and vast shale oil deposits, which are accompanied with an infrastructure that fails to (profitably) transport and export the cheaper WTI oil that, in theory, could have been exported. Greater exports of WTI oil would reduce the price differential between WTI and Brent crude. This means, for the moment, good news for manufacturers close to the source, close to the regions where WTI oil is extracted. These domestic manufacturers have access to cheaper oil than some of their foreign counterparts. This, however, hardly reduced any optimism about the future of energy in the United States, since for the first time in history, the United States became the largest oil-producing country in the world, a clear sign of the radical shift of power that occurred in global crude oil markets.

Federal Reserve Acknowledges Drop in Business Investment

Last week, the Federal Reserve also published the minutes of the most recent FOMC meeting. Even though these minutes are among the least exciting documents that can be found on financial markets, markets look closely for clues on future Fed policy. Every time, roughly three words are modified and investors try to deduce as much as possible (too much) from the few changes that the Fed makes every now and then.

Notable was the fact that the Fed clearly admits that – despite Trump´s tax reform – business investment is weakening severely. This is something that I have discussed on earlier occasions: Trump´s tax reduction actually stimulates consumption and not business investment and capital accumulation. Moreover, the money that was repatriated from abroad because of a one-off tax discount (part of Trump´s reform) by large corporations, was simply spent on stock buybacks, rather than capital investment. Fixed investment did not go up after profits booked abroad were repatriated to the U.S.

It could easily be the case that the Fed – which decided not to raise, as expected, interest rates this month – will raise interest rates in December to a level of two and a half percent on reserves. This is bad news for the yield curve (which has already been flattening for the past year), but also for long-term rates. Long-term rates are starting to react to the Fed´s rate hikes. The 10-year rate on US Treasuries rose to levels topping 3.20%.

Moreover, the debt servicing of U.S. public debt (interest payments) are also starting to mount. More than $550 billion is currently spent on interest and a large part of the most recent rate hikes have not yet been felt in the current interest expense. This is perhaps the most frightening trends we can observe in today´s markets, given a complete unwillingness on the part of Trump himself – and now in all likelihood also a complete impossibility given the Democratic majority in the House – to reduce government spending. The fiscal deficit of a staggering 5% of GDP will – most likely – only further increase given these circumstances (higher rates and no spending cuts).

And all this translates into a positive outlook for gold, albeit in the long run. Initially, gold prices barely moved, while the dollar strengthened (to 1.13). Initially, because gold prices would later fall back to $1200 per troy ounce as it became clear that the decline in oil prices was not about to slow down.

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