Friday, February 24, 2012
We have been saying it for weeks, and today even the WSJ jumped on the bandwagon: the sole reason why crude prices are surging (RIP European profit margins: with EUR Brent at a record, we can only assume the ECB will pull a 2011 and hike rates in 3-4 months even as it pumps trillions in PIIGS, banks bailout liquidity) is because global liquidity has risen by $2 trillion in a few short months, on the most epic shadow liquidity tsunami launched in history in lieu of QE3 (discussed extensively here in our words, but here are JPM‘s). Luckily, the market is finally waking up to this, and just as world central banks were preparing to offset deflation, they will instead have to deal with spiking inflation, because the market may have a short memory, it can remember what happened just about this time in 2011. And the problem is that when it comes to the inflation trade, the market, unlike in most other instances, can be fast – blazing fast, at anticipating what the central planning collective’s next step will be, after all there is only one. And if Bank of America is correct, that next step could well lead to the same unprecedented economic catastrophe that we saw back in 2008, only worse: $200 oil. Note – this is completely independent of what happens in Iran, and is 100% dependent on what happens in the 3rd subbasement of the Marriner Eccles building. Throw in an Iran war and all bets are off. Needless to say, an epic deflationary shock will need to follow immediately, just as in 2008, which means that, in keeping with the tradition of being 6-9 months ahead of the market, our question today is – which bank will be 2012’s sacrificial Lehman to set off the latest and greatest deflationary collapse and send crude plunging to $30 just after it hits $200.
How do we get to $200 crude? BofA’s Francisco Blanch explains:
Oil could spike to $200/bbl to further slow down demand
In a supply-constrained world, however, oil is unlikely to spend much time hovering around its price floor. Rather, we believe oil prices will likely remain a key constraint on global economic growth. This suggests that prices will continue to spike over the next five years to keep on rationing demand back down to the limited available supplies. As we have highlighted before, the world economy can hardly afford to spend more than 9% of its GDP on energy (Chart 4). But central banks such as the Fed or the ECB will likely remain focused on expanding their nominal GDP values to smooth out the ongoing deleveraging cycle in the US and European economies. In a supply constrained world, increased liquidity should set oil prices on an upward path. In other words, as nominal global GDP in USD expands to $92tn through 2016, demand rationing will likely require ever higher $/bbl prices. On our estimates, occasional demand rationing episodes could result in prices occasionally spiking to $200/bbl over the next five years (Chart 5).
And for the nth time, IT IS ALL THE CENTRAL BANKERS’ FAULT!
High liquidity is likely boosting Brent crude oil prices
As we have explained in previous notes, the prices of constrained real assets tend to appreciate in times of ample liquidity. Oil prices are no exception and have been supported by the environment of negative real interest rates prevalent in DM, in our view (Chart 6). Using historical data on USD real interest rates, we have previously tried to estimate the impact of negative interest rates on oil prices (Chart 7). Our conclusion is that a 100bps decrease on USD real interest rates historically increased Brent crude oil prices by more than 6% in the subsequent year.
Liquidity impacts oil prices through several mechanisms
This negative correlation between real rates and oil prices is the result of several mechanisms; some very direct and some more subtle. First, not all sectors of the economy respond in the same way to monetary policy. As a sector with severe supply constraints, oil prices should behave differently from other prices in the economy when demand is expanding (or contracting less) due to easy monetary policy measures. In addition, if easy monetary policies are to force consumers to consume and companies to invest, the impact of low real rates is likely to gear consumption towards durable goods and investment towards infrastructure, both of which are energy intensive components of GDP. Finally, oil producing nations have very little incentive to produce beyond their budgetary requirement if returns on their assets, held in international reserves or in a SWF for instance, are yielding below inflation expectations (Chart 8).
The only solution: price exhaustion, plunging margins, and a deflationary shock, yet one which is unexpected and stuns the market out of the liquidity feedback loop. Lehman 2.0 anyone?
High prices will ultimately cure high prices
But oil prices cannot go up forever. Should the price differential to natural gas stay this wide or even continue to widen, large-scale substitution could come into play. Substitution out of oil has been going on for decades, but the price differential between oil and other fuels is now at record levels (Chart 9). Inevitably, ingenuity will trigger unforeseeable changes in energy demand patterns on a ten year time horizon. So even if the super-cycle in oil continues for the next five years on tight supply and demand balances, new technologies should start to reduce global oil consumption in a meaningful manner by 2016. Having said that, we believe that oil will continue to trade at a substantial premium over other fuels through the end of the decade, even if the current Brent crude oil to US natural gas price ratio of 10 to 1 seems unsustainable in the long run.
Luckily, we have seen this all play out before: liquidity surge, collapse, rinse, repeat. Only in the meantime it is only the lower and middle classes that lose. Prepare to see some astronomic numbers in crude, gold and all other commodities before the cycle is primed for repeating all over again.
This article was posted: Friday, February 24, 2012 at 9:10 am