Tag Archives: financial advisor

7 Quick Points On Europe

europeMy Comments: My purpose with this post is to confuse you. Yes, that’s right, to confuse you. That’s because even though I claim to be a financial professional of almost 40 years duration, I’m confused. And I don’t want to feel alone.

This came across my inbox inside a newsfeed I look at daily which suggests it’s not that esoteric. The title itself lends it credibilty. That’s because most of us are interested in making our money grow and that Europe’s financial state over the next several months is critical. But it may just be an example of an economist talking to himself.

It’s not too long so I ask you to read it and let me know, if you can, just what it means. Thanks.

Ben Hunt, Epsilon Theory / Jan. 28, 2015

#1) Here are the most relevant recent notes for an Epsilon Theory perspective on the underlying political and market risks in Europe: “The Red King” (July 14, 2014) and “Now There’s Something You Don’t See Every Day, Chauncey” (Dec. 16, 2014).

#2) Markets reacted positively to last Thursday’s announcement because Draghi doubled the amount of QE that he leaked to the press on Wednesday. Financial media pegged QE at 600 billion euros on Wednesday and 1.2 trillion euros on Thursday. Once again, Draghi played the Narrative game like a maestro.

#3) This is NOT open-ended QE. Sorry, but the Narrative game doesn’t work like this. If you mention a target date (September 2016), then that becomes the Schelling focal point, no matter how much you try to walk that back by saying it’s open-ended.

#4) Risk-sharing, or the lack thereof, matters. Draghi won approval of a doubled QE target by minimizing the mutualization of QE risk among EU countries. 80% of the bond-buying will be done by national central banks, and Germany will only buy German government bonds, France will only buy French bonds, etc. That’s important for two reasons. First, if Italy or Spain goes off the rails, then the Bundesbank’s balance sheet isn’t immediately crippled.

Second, this is why German bonds are rallying just as hard (harder, really) than periphery bonds. It’s also why US bonds are rallying so hard, because you can’t maintain a huge spread between the only risk-free rates left in the world.

#5) Market complacency on Greece is a mistake. Not because Greece itself is a huge systemic threat, but because the same political dynamics in Greece are coming soon to Italy. Greece is Bear Stearns. Italy is Lehman.

#6) In tail-risk trades as in comedy, timing is everything. Even if you think that it’s an attractively asymmetric risk/reward profile to bet on a Euro crisis (and I do), this is a heavily negative carry trade. If you don’t know what the phrase “negative carry trade” means, then please don’t make this bet. If you do know what it means, then you know that you either have to play a lot of hands to make the odds work out for you (and the nature of systemic crises makes that impossible) or you have to be spot-on with your timing.

#7) In a fundamentals-driven market you need to look at fund flows; in a Narrative-driven market you need to look at Narrative flows. With Draghi’s announcement last Thursday, there is no longer a marginal provider of market-supportive monetary policy Narrative. Or to put this in game theoretic terms, the 2nd derivative of the Narrative of Central Bank Omnipotence just flipped negative. We’ve shifted from an accelerating Narrative flow to a decelerating Narrative flow, and that inflection point in profoundly important in game-playing. The long grey slide of the Entropic Ending begins.

Medicare Advantage after PPACA

healthcare reformMy Comments: OK, I understand it; you’re sick and tired of posts about the PPACA and the crap our so-called leaders in Congress are doing to muddy the waters. Unfortunately, access to affordable health care is what tends to keep us alive, never mind that the system is mostly a sickness treatment system and not a wellness system.

The fact remains that the doom and crisis promoted by a certain political party in this country has not come to pass. Indeed, some of the most vigorous opponents are now cozying up to the idea by promoting a variant of it in their home states. This article talks about just one element of the national health debate.

Jan 25, 2015 | By Danielle Kunkle

For several years now we’ve heard warnings that billions of dollars in funding cuts to Medicare Advantage plans under the Patient Protection and Affordable Care Act will result in reduced benefits and higher premiums as well as smaller provider networks and fewer plans.

In fact, the Congressional Budget Office projected the cuts would result in three million fewer enrollees in MA over the long run.

In the short run, however, plans seem to have done a great job keeping coverage as affordable as possible, and enrollment in MA plans remains high.

There’s nothing like worrying about healthcare, especially how you’ll pay for it in retirement.

Will this trend continue? It’s hard to say. As of January 2015, only 20 percent of the total legislated cuts have been phased in, and while many seniors in MA plans already are absorbing higher cost-sharing, there’s been no tremendous public outcry thus far.

There’ve also been some measures enacted to mitigate some of the impact of those cuts that have been phased in already, so the real impact of PPACA on plans will become clearer in the next few years. Let’s take a look at the big picture.

PPACA changes how insurers are paid

Some legislators felt MA plans were being overpaid for the benefits they deliver, and that to bolster the solvency of Medicare itself, the nation needed to lower payments to MA insurers.

In essence, PPACA aims to slowly lower Medicare Advantage payments over time until the government pays the same amount per beneficiary whether they enroll in original Medicare or an MA plan. Most Medicare plans began receiving less pay in 2012 but the cuts are to be phased in from 2012–2017, so we have a ways to go yet.

Under PPACA, plans also can qualify for a bonus payment for providing better care. Plans have to report data detailing how many of their members are routinely getting preventive care under the plan, as well as how many get additional support in managing chronic conditions such as diabetes. Plans receiving higher star ratings get higher bonuses, with the desired result being that the bonus program will encourage plans to focus on delivering a higher quality of care, thus increasing the value of the health care dollars spent by consumers.

The downside is that some plans linger in the 3 to 3.5 range, and might not survive long enough to reach the 4 to 5-star level that provides needed benefit dollars to survive.

Mandated benefits changes
PPACA also introduced a new mandatory cap for all Medicare Advantage plans designed to cut member costs. The cap limits the total out-of-pocket costs a member can incur for Medicare covered services each year. The limit is set to $6,700 in-network right now, which is substantially lower than limits many plans had before the law and thus results in higher spending by the plan.

The law also stipulates that plans can no longer charge members more for than Original Medicare for certain services such as chemotherapy and skilled nursing. Plans have had to revise benefits to come in line with this rule, and this means they’ll pay out more than they did before.

Going forward overall, plans also must spend at least 85 percent of premiums gathered back out on benefit, and the remaining 15 percent must pay for marketing, administrative expenses and of course, profits.

Enrollment grows anyway

So, in light of all these scheduled funding cuts, why have we seen MA enrollment continue to grow? Well, there have been extenuating circumstances.

The American Action Forum gave testimony in July that plans have been largely shielded so far because the Administration has used demonstration program dollars to partially offset the first phases of PPACA benefit cuts.

These project dollars end in 2015. The Administration also has backed down two years in a row on proposed payment cuts. A scheduled 2 percent cut in MA payments in early 2014 was avoided when CMS announced a 3.3 percent increase in payments, and this allowed plans to keep some benefits that may otherwise have been cut.

These extra dollars have kept benefit changes relatively minor. The Kaiser Family Foundation reported that about half a million beneficiaries had to find new plans for 2014 because their prior plan was no longer available. Many argue beneficiaries are overwhelmed anyway with too many plan choices, so fewer plans could be a good thing.

Some other beneficiaries have experienced doctor changes. Shrinking networks have made national news this year, with one large carrier terminating as many as 15 percent of its in-network physicians. Trimming networks is a common way plans can absorb funding cuts without having to change benefits drastically. Doctors with a record of providing the most cost-effective care get to stay in the network while others are booted.

While this is always disruptive for the members affected, these beneficiaries generally switch to another Medicare Advantage plan rather than take on the added expense of Medigap. The same can be said for beneficiaries who saw MA premium increases, on average, of about $5 per month. A change like this doesn’t make someone suddenly want to go out and spend $150/month or more on a Medicare supplement. They simply change to a different Medicare Advantage carrier.

Agents who work in the senior market know that even small increases like a $5 increase in a doctor copay will often result in the member seeking to change plans. Unfortunately, when the other available plans also have had similar increases, members soon learn to just grin and bear the changes. So enrollment continues to grow because the people experiencing changes have nowhere else to go that’s more affordable.

Lastly, people new to Medicare are already used to health insurance plans with higher cost-sharing. They never experienced earlier plans that had richer benefits, and at age 64, many are paying many hundreds of dollars for insurance with high deductibles. To them, a Medicare Advantage plan with even a premium of $70 or more is a relief.

Calm before the storm?

What remains to be seen is how the plans will weather the rest of the cuts that are scheduled to phase in over the next few years, and how many times the Administration or Congress will step in to soften the cuts.

We’ve been kicking the can down the road for years on scheduled cuts to physician fees, and perhaps that’s the future for Medicare Advantage as well. Stay tuned.

Good Company, Bad Stock

retirement_roadMy Comments: This post is to remind you that stock market performance and the state of the economy do not follow the same track. From time to time there are close parallels, but they dance to a different drummer.

My arguments that the stock market is due for a crash are unrelated to the state of our economy. They are also unrelated to the name or party of the President in office at any given time. Obama cannot take credit for the current economic strength nor can G.W. Bush be blamed for the crash that happened in 2008. That I am also a Democrat is also irrelevant.

The stock market is going to crash again, and you need to be prepared if you have money exposed to what will be an unpleasant period. Period.

January 30, 2015 / Commentary by Scott Minerd

The U.S. economy is strong relative to other countries, but its equity valuations mean less upside potential for long-term investors than other areas of the world.

The U.S. economy is in the best shape out of any economy in the world, but it reminds me of a great business with a bad stock. Despite its underlying economic strength, I believe U.S. equity markets are likely to underperform those of less healthy economies in the long run. When I look around the world at economies that have many more problems than the United States, I see more upside potential for equity valuations and market performance in places like Europe, China and India.

Certainly, the United States is in a self-sustaining recovery—already the fifth-longest economic expansion since World War II. Despite noise this week around the 3.4% decline in durable goods orders, recent economic data releases continue to be positive: new home sales rose to a 6.5-year high and the Conference Board’s Consumer Confidence Index surged to 102.9 in January, the highest since August 2007. The U.S. economy remains the engine sustaining global growth, but when it comes to equity market valuations, a lot of the risk premia are out of the market.

One of my favorite macro-valuation tools is to compare total stock market capitalization to underlying gross domestic product (GDP). In the United States, this ratio is currently 134 percent, the highest level since the third quarter of 2003, the year this global comparison data became available. By the same measure, equity valuations in the euro zone, China and India are much lower. China’s equity market capitalization, for example, is 51 percent of its GDP, significantly below the previous high of 101 percent registered just prior to the global financial crisis.

As policymakers around the world introduce measures to reflate their economies and implement structural reforms to release growth potential, I wouldn’t be surprised to see Chinese, European, and Indian equities outperform U.S. stocks in the long run.

Switching to the bond market, I’ve been bullish since last fall that rates in the United States would decline to 2 percent or lower. In the near term, rates probably will fall further, but given that we’ve come more than 120 basis points since the beginning of January 2014 (as of yesterday’s close), it seems that the best part of the bull market in U.S. rates is over.

If it weren’t for quantitative easing in Europe and the deflationary shock coming out of oil, we would see U.S. rates meaningfully higher than they are today. With inflation likely to start picking up in the second half of the year, wage growth likely to start showing strength due to increases in minimum wage (20 states increased minimum wage effective Jan. 1), and the prospect that the Federal Reserve will probably increase rates at some point in the second half of the year, the vulnerability to rates rising will increase as the year plays out.

This will mean tough sledding for most of the bond market, but it’s not necessarily bad news for the U.S. economy. Even if rates rise modestly and a lot of the juice leaves the equity markets in 2015, the underlying economy is just fine and will continue to be just fine.

Foreign Markets May Offer More Growth Potential

U.S. stock market capitalization as a percent of GDP is at its highest level since the third quarter of 2003, the year this global comparison data became available. By the same measure, equity valuations in the euro zone, China and India appear much lower. As central banks in those countries implement policies to reflate their economies and structural reforms take hold, stock markets in those countries may present more attractive opportunities in the long run.

Military Retirement Faces Shake-up

FT 11FEB13My Comments: I did not serve in the military; I failed my draft physical way back in 1959. They gave me a 1-Y classification that said ‘only in case of national emergency’. I don’t think I was upset since by then I was a freshman at the University of Florida and VietNam was looming on the horizon.

All the same, I’m sensitive to those who did, especially all the millions who served and survived and spent years in the effort. And as someone now of an age when retirement is normal and expected, making sure the benefits for those who worked long hours for all of us is financially secure is important.

Here’s a short glimpse into what is going on. As a financial planner of many years, this makes sense to me.

Jan 28, 2015 | By Marlene Y. Satter

A long-awaited report on the military’s compensation system will include proposals for sweeping changes in how retirement is approached, the Military Times reported Wednesday.

The newspaper, citing anonymous sources familiar with the report, said its provisions will include a phase-out of the current system, which allows service members to collect a benefit immediately upon retirement after 20 years.

A hybrid system is set to be proposed as a replacement, one which will incorporate a smaller defined benefit plan, lump-sum payments and more cash-based benefits.

In addition, the new system would incorporate a 401(k)-type investment account as a significant portion of a service member’s retirement benefit.

The new plan would automatically enroll service members in the government’s Thrift Savings Plan, with service members being responsible for managing their own accounts.

Money in the TSP is not accessible without penalty until the participant turns 59½. Troops would be required to serve a minimum period of time before they are eligible for full ownership of the account, and the government would likely contribute a percentage of basic pay that could vary based on years of service and deployment status.

In addition to the 401(k)-type benefit, there would also continue to be a DB component to the plan, but the coming proposal is expected to make it more modest than at present and restrict its availability until age 60 or perhaps even later.

Such proposed changes not only would have to be approved by Congress, but would affect only new recruits. Currently serving military personnel would be grandfathered into the existing system.

The Military Times said companion proposals to change the health benefits offered by the military are also expected, although they would likely affect troops presently serving — should such proposals manage to pass Congress.

Germany Is Delusional To The Point Of Insanity

global investingMy Comments: Assertive headlines such as what you see here are usually outside my comfort zone. For one it implies a pathology that I’m not trained to comment on and two, Europe and European values are different from mine, given that I’ve lived here in the US for the past 65 years. (Warning: this post is LONG.)

That being said, what goes on in Europe does influence what happens to our markets, and since investing money is an expertise I have, then knowing and trying to understand this sort of thing is important to me. And perhaps to you.

The Mercenary Trader / Jan. 21, 2015

“It is as if it’s accepted that the euro area’s modus operandi is to clear things with Germany, and for the ECB to constrain its actions to what is best for Germany.” ~ Athanasios Orphanides, former member of the ECB governing council

Most of the eurozone is experiencing deflation. Even the countries who aren’t – Germany etc. – are well below the ECB’s official 2% inflation target.

This is dangerous because deflationary conditions can tip into recession… and depression… and political extremism born of civil unrest. Deflation – or rather the extreme results of such, in the aftermath of harsh slowdown – brought us the Nazis in the 1930s. Post-Weimar economic implosion, not currency erosion, enabled the political conditions for Hitler’s rise to power.
Need we say more?

Apart from political unrest, deflation is like having no fuel in the emergency flight tank.

A lot of people will say “what’s wrong with deflation,” e.g. why is it so bad?

It’s important to clarify there is a big difference between falling inflation levels (disinflation) and inflation falling below zero. Think of a plane that stalls out.
When an economy goes negative, the risk is that the plane fails to overcome the stall… and crashes before it can pull up. Deflation (as opposed to disinflation) can lead to compounding “downward spiral” impacts, not unlike gravity’s increasing pull on a nosediving airplane.

The German attitude toward inflation, and debt, is pathological (indicative of mental disorder).

Germany is paranoid of inflation on a pathological level. Germany is also pathologically allergic to debt. Consider, for example, that Germany as a country has serious infrastructure needs… and there is real risk that Germany’s economy will slow in future. Right now, German interest rates hover above zero (or even dip below it). This is a historic opportunity for “good” financing… for logical spending on real needs, financed by incredibly low-cost debt.

Yet Germany is so debt averse, they aren’t willing to borrow for the future – not even for themselves – even with rates in the zero to one percent range. That’s almost the equivalent of turning down free money, even when it is badly needed for repairs… even when it has obvious strategic use. That is not frugality as a virtue, it’s more like a miser complex worthy of therapy.

Worse still, Germany is delusional about its own economy and dangers.

Think about this: What happens to the German economy when China really and truly slows? And what happens to the German economy when Japan goes “next level” in its competitive devaluation plan?

China is slow-motion imploding. No matter what happens, China has to switch from an infrastructure led economy to a consumer led one. This is very bad news for Germany, one of the world’s largest exporters. As is the increasingly competitive currency stance of Japan. Bottom line: Germany’s present economic strength could easily evaporate… for strong reasons that make logical sense. And how much cushion would they have in that event? None…

Bottom line: Germany would rather slit its own throat, economically speaking, than allow for a rational approach to inflation and debt.

That is a deliberately harsh phrase, it’s true. But the writing is on the wall. Germany’s commitment to austerity is not just pathological, it is economically suicidal.
The entire eurozone is at risk… and Germany’s own economy is too… and the lessons of history speak loudly. Yet Germany continues to live in a bizarro dream world where saving money has been elevated to a fetish regardless of surrounding circumstances.

We don’t choose to pick on Germany. We have friends who are German… family members and loved ones with German roots. It simply “is what it is.” The pathologies of a country, to the degree they go separate ways from rationality, are leading to economic disaster (and who knows what in the aftermath).

There are questions as to whether German provisions will “neuter” euro QE.

Draghi and the European Central Bank will announce some kind of quantitative easing on Thursday (sic). There is no question of it now. If they tried for another stall – more “wait and see” – European equity markets would simply go into freefall. Investors would start betting on accelerated odds of euro break-up.

But it remains possible that the “shock and awe” of euro QE will be neutered by German demands. Via the FT: To appease QE’s German opponents, which include the chancellor Angela Merkel herself, Mr. Draghi is expected to say that bonds bought will remain with national central banks, so losses will not be spread among eurozone members. But other eurozone countries, as well as the International Monetary Fund, fear the concession could reduce QE’s effectiveness…

OF COURSE giving Germany what it wants would reduce euro QE effectiveness!

• Germany wants to reduce fiscal exposure to weaker eurozone members.
• But establishing a united support front is the whole idea in the first place!
• The house is on fire and liquidity crisis measures (firehoses) are needed…
• But Germany wants to avoid charges for the water…
• And make sure any fires are segregated away from itself…
• Thus increasing the odds the whole thing burns down.

The German justification for not wanting to participate is ridiculous.

The stance of Germany is essentially, “Why should we pay for these bums? Why should we create more risk exposure for ourselves? We are savers, they are spenders… why should we waste money on them?”

The answer is that Germany should have asked those questions SEVENTEEN YEARS AGO. Saying “Nein!” to an insanely stupid monetary union would have been very logical, and the best thing for all… circa 1998 before the euro actually launched! But now it is too late to avoid responsibility for actions.

What’s more, it is no longer a “moral” question… but a question of WHAT THE RISKS ARE.

This is the other amazing / maddening thing about the German stance. Germany still acts as if there is room to say “no” on moral grounds… when the final question is what will happen, not what is right or wrong. When a course of action is highly likely to invite DISASTER, the question of right or wrong has to be put aside…

Because of Germany, we don’t know how euro QE will come across… but we are willing to short more FEZ against our euro position. Our EURUSD position has a sort of partial absolute hedge in short European equities. If Germany throws a spanner in the QE works, and “Super Mario” disappoints, EURUSD could spike in a big short squeeze. But European Equities (NYSEARCA:FEZ) would fall hard in that instance. Conversely, if Draghi and the ECB come through in a big way, the reverse could occur – EURUSD goes into freefall, FEZ rockets higher. So they act as de facto hedges of each other…

Another scary thing… even if Draghi gets his “big bazooka” QE… what good will it do?
The other frightening thing to consider: It may be too little, too late for Europe no matter what size of QE they get. There is little point in lowering eurozone bond yields (already pressing zero). And there is little real hope in stimulating bank lending. So the true point of euro QE would be… what? Making the euro a hell of a lot weaker to stimulate exports one supposes. What else is QE supposed to do?

One argument is that, once euro QE starts, it never stops… until it goes nuclear…
Some argue it doesn’t really matter how much QE the ECB starts with… because QE just gets bigger from that point no matter what. We can’t be sure this is true. Germany might try to stop a “failed” QE program. Then again, if things get really ugly – e.g. if Germany falls into recession too – then maybe it keeps going and going…
And the ECB finally winds up going “nuclear,” taking a page from Japan. Understand this: There are plausible scenarios where the euro goes to 85 cents before all is said and done. That outcome would not be too hot for risk assets. (Hello understatement!)

the Future of Medicine is…

healthcare reformMy Comments: I claim no authority on this topic. However, because I often work with physicians, I’m very aware of the pressures that apply to the profession. There are many issues on which no individual has any control, one of them the apparent erosion of the profession in terms of college graduates not seeking admittance to medical school.

Demographics alone tells you there is likely to be a need for MORE physicians in the coming years, not less. How do we as a society create the conditions that will cause this demand to be met? Is there a way? What has to happen?

While this comes at the problem from the negative, there are lessons here, even though the message comes from Great Britain.

November 19, 2014 / By Clive Cookson / The Financial Times

The Reith Lectures 2014 on The Future of Medicine, Atul Gawande, BBC Radio 4, from November 25

We all know how personal anecdote can illuminate talks about grand themes such as the future of medicine. But few speakers carry off the art of storytelling as well as the surgeon and writer Atul Gawande in this year’s Reith Lectures on BBC Radio 4.

FirstFT is our new essential daily email briefing of the best stories from across the web
The first of four, “Why Do Doctors Fail”, to be broadcast on Tuesday, was recorded in Gawande’s home city of Boston, where he is a medical professor at Harvard University. It begins with a poignant account of his son Walker severely ill in a local hospital almost 20 years ago. The 11-day-old boy almost died because an oxygen probe was attached to a finger on his right hand when it should have been on the left hand.

The blood oxygen reading suggested to the emergency room staff that Walker’s problem lay in his lungs, when in fact the failure was cardiovascular – his aorta had not developed properly. An alert paediatrician detected the error just in time to open up Walker’s circulation but not in time for a baby in the next bed with the same diagnosis, who suffered multiple organ failure.

Gawande weaves the details of Walker’s illness and recovery into his exploration of the nature of fallibility in modern healthcare. As he says, doctors have acquired an enormous arsenal to fight disease and promote good health but far too often avoidable mistakes stop it being used to best effect.

“The story [of medicine] has become as much about struggling with ineptitude as with ignorance,” he says.

The second lecture, “The Century of the System”, was recorded in London and starts with an even longer story. Gawande devotes the first nine minutes of his 25-minute talk to a three-year-old Austrian girl. She “drowned” in an icy pond and was brought back first to life and then to health through a complex sequence of procedures, which Gawande describes in gripping detail.

The point is that great complexity is inevitable if patients are to benefit fully from modern medicine. But it only works – as with the Austrian system, which was developed originally to treat avalanche victims – if everyone knows his or her role and follows procedures.

“We have been fooled by penicillin” into imagining that medicine is about simple cures, Gawande says, while in reality it is about complex solutions to complex problems. This requires effective systems, implemented with the help of checklists of the sort that are routine in other safety-critical industries such as aviation but only now being implemented in healthcare.

Checklists have cut complication and mortality rates in hospitals around the world, as Gawande points out. A minority of surgeons dislike checklists on the grounds that they interfere with individual brilliance and daring, an objection that he dismisses with the memorable statement: “Discipline makes daring possible.”

Sue Lawley, who has presented and chaired the Reith Lectures since 2002, rightly calls them “the epitome of public service broadcasting”. They were inaugurated in 1948 to honour John Reith, the BBC’s first director-general, who believed fervently in the corporation’s duty to enrich the intellectual life of the nation. Gawande follows several figures from science and medicine who have given memorable Reith Lectures. Although listeners who have read his books such as The Checklist Manifesto will recognise recycled material, his warm and clear delivery gives it fresh appeal. And everyone will love his stories.

Current Oil Price Decline May Set Stage For Price Spike And Global Recession

oil supply+demandMy Comments: There are relatively high taxes on the sale of gasoline at the pump where I live. In spite of this, we are almost at the $2.00 per gallon level. As I’ve mentioned before, this is both a good thing and a potentially bad thing.

The bad is that money invested to bring us domestically produced fuel and money invested to develop fuel efficient cars and trucks will be diverted and will appear somewhere else. Long term that is not a good thing for us. The world is evolving, as it has forever, and anomalies like what we are now seeing will have consequences.

Zoltan Ban / Dec. 30, 2014

• Current oil price decline is likely to lead to significant investment cutback, which will affect supply for many years to come.
• When the price of oil starts to recover, it will very probably spike, as there will be no supply mechanism able to react fast enough.
• A price spike will only be broken by a recession. It could be the beginning of a period of repeating such cycles.

For a few months now, there has been a very spirited debate in regards to the net effect lower oil prices will have on the economy. There are some who point to lower prices potentially bankrupting a large number of oil & gas companies, especially those that are mainly reliant on high-cost unconventional resources, such as shale oil, therefore it is bad for the economy. Others point to consumer demand being stimulated by the lower price of oil, which effectively acts as a tax cut for most households.

My take on the entire argument is that it is not as relevant as the fierce debate surrounding it might suggest. The effect on the economy might be a slight positive and the longer the lower price lasts, the stronger the effect. But there is no denying the fact that there are many oil extraction projects around the world that are not profitable at current price levels, therefore it is only a matter of time before the current price decline will lead to a drop in global production. Furthermore, even countries where the oil industry is mainly dominated by state-owned enterprises and production costs may be lower than the current price level, there will be a significant cutback in capital spending, because many of these governments are very dependent on oil revenues for their budgets. It makes perfect sense for a country like Russia for instance to cut investments in new projects until prices recover, in order to free up revenue for other government needs.

The effect of some investment cuts will be more immediate as may be the case with oil sands and shale oil. In the case of other expensive projects such as deep-water, the effects may only be felt many years from now. We have no way of knowing yet how deep the cut in production potential will be over the next few years, in part because we don’t know yet how much capital will be cut next year. Goldman Sachs projects that there may be a need for as much as a 30% cut in non-government owned projects around the world in order for the industry to avoid collectively taking a loss. ConocoPhillips (NYSE:COP) announced it will cut spending by 20% next year and it should not come as a huge surprise if it will cut even more as the year progresses (link). Many companies involved in shale drilling already announced they will cut their drilling activities next year. The announcements of plans for lower oil & gas investment are now coming in at a fast pace.

We have to realize that it will in fact not take much of a cut in the rate of growth in global oil production in order to close the relatively small glut in oil supply. The gap between supply and demand will be only about 400,000 b/d in 2014. It would have increased to about a million barrels per day by next year, if the supply/demand forecasts for 2015 would have turned out to be more or less accurate.

Thing is however that many projects take years from beginning till completion, so the effect may be felt only a few years from now. There will also be a slowdown in global production growth, especially in North America, where much of the global increase in production comes from since 2008, which will have a more immediate effect. Oil sands and shale oil projects do not have such a long lead time. If there is to be a reduction in supply in order to bring the market back into balance, it will most likely start with a decline in North American production growth, or even a decline in production.

As we can see from the chart, the US and Canada provided all the growth in oil production that the world needed since 2008. If the current low oil price will persist, it is probable that the shale oil industry in particular may suffer significant and probably permanent damage. The industry is vulnerable in large part because to date there has been very little self-sustaining growth in the industry. In other words, revenue re-investment is not sufficient by itself to push production volumes up. The main ingredient in the shale revolution has been the availability of credit. One of the main outcomes of the shale revolution has been the accumulation of about $170 billion in junk debt by many companies which are rated below investment grade (link). If the market will cut the industry off from continuing to accumulate debt, production will eventually stagnate and possibly decline as companies will have no choice but to cut back on drilling.

The production decline should help to stabilize the price of oil and eventually work towards the old plateau established starting from 2010, as long as there will be no global economic slowdown. The main problem I see is that when the price of oil will start to move back up, in response to a tighter supply/demand situation, there will be no mechanism in place to prevent the price of oil from overshooting. In other words, it will not stop at the tolerable $100 level we learned to live within the past few years, but continue climbing until demand destruction will occur. That means we are most likely looking at a global economic slowdown.

The reason I believe that the price will overshoot, is because just as there has been very little to keep the price of oil from falling in 2014 as for the first time in years there is a significant level of over-supply, there will also be little to keep the price from spiking as prices will rise too fast for new supply to catch up. The cuts in investment we are seeing right now will affect supplies for the next five years and even beyond. The extra spending companies will engage in once prices recover may in fact provide extra supply only once it will be too late. The recession inducing price spike could happen within a period of just a few months once the upward trend is established, while new supply may take many years to come online in response to the higher prices. In fact, the new supplies may come online only once the price of oil crashes again as a new recession takes a bite out of demand.

Future nostalgia for $100 oil plateau.
At an average price of about $100/barrel in the 2010-14 period, it was not a pleasant situation by any means. That price range was much higher than historical trends and it took out a bite out of potential global economic growth, given an economy that was built around much cheaper oil in past decades. Now that the price of oil is at a level that is more in sync with the economic needs, most of us feel much better about things overall. Pimco recently upped its estimate for global economic growth, citing lower oil prices, which will stimulate more consumption of all goods.

Needless to say that even though the economy feels better with the current oil price levels, many of the oil companies involved in producing the oil are not feeling all that great right now. That is especially the case with shale oil producers. What is worse, their financiers are not feeling all that great about them either and probably will be more cautious of them even when the price of oil will increase. As I pointed out in a previous article, there can be no shale oil production growth without the backing of lenders, because the industry cannot sustain itself from production revenue, which was the case even when the price of oil was in the $100 range (link). This is a very important fact to keep in mind, because resources such as shale oil and Canadian oil sands are the resources which could be the fastest responders to the price signal sent once oil prices start rising again.

With the response to the price increase much delayed and insufficient, there will be nothing else to stop the price from rising, except demand destruction and as we well know, demand destruction of oil means a recession, because oil is a very inelastic product. A recession will in turn cause prices to go back down again, which means that oil producers will have no choice but to cut back on investment once again, just as they are increasingly doing now. It is possible that we will be caught up in a long period of repeated cycles of oil price spikes and plunges, with the price failing to stabilize as it did after the 2009 price drop. The resulting effect on the global economy can potentially be devastating.

There is only one potential factor which could help prevent such a situation and that is OPEC action. All indications are however that OPEC is no longer in the business of oil price stability. I will not speculate on the possible reasons why Saudi Arabia seems to be unwilling to stabilize the global oil market, because there has already been plenty of speculation in that regard already. We can only go on what we actually know right now, and what we do know is that OPEC is currently dysfunctional. As I pointed out many times in the past year and a half or so, the current WTI price range that is sustainable more or less from both the consumer and producer perspective seems to be $80-120, with the price ideally spending most of the time in the middle of that range. We are now obviously very far outside that range, and when prices will recover, there is a very good chance that the price will overshoot the ideal range. If we will be unable to once again stabilize within the range I suggested, we will be looking at a period of great economic upheaval for many years.