Crude cause and effect
Donald Luskin, chief investment officer and founder of Trend Macrolytics, has worked as an entrepreneur, executive, investment manager and commentator for more than 30 years. He is an expert on the application of technology and innovation to the challenge of investing.
Prior to founding Trend Macrolytics, Luskin was Vice Chairman of Barclays Global Investors (acquired by Blackrock), where he worked with institutional investors to create innovative indexing and quantitative investment management strategies. Luskin invented the POSIT ECN, and founded the Investment Technology Group at Jefferies & Company. He has worked as a hedge fund manager and an options market maker on several exchanges.
Luskin, who takes a long-term approach to analyzing global macro trends in markets, often appears as a global macro expert across the business media circuit. His unique analysis frequently goes counter to the prevailing wisdom of the day and his market outlooks have often been prescient.
We speak with Luskin about how the dramatic drop in crude oil prices has affected the global economy and how it will likely affect it in the future.
Modern Trader: Is global economic weakness causing lower crude oil prices or are lower crude oil prices causing global weakness?
Donald Luskin: I don’t think there is any real debate about that. Oil peaked in June 2014. We’re now 20 months into this and over that period global demand for crude oil is higher today than it was 20 months ago. The oil price has fallen 70% while oil demand has increased so that’s proof that this is [not a demand issue]. This is a supply-side issue. There has been a vast increase in the ability and the known future ability to produce oil on this planet. That’s changed the balance of supply and demand, it’s caused the OPEC cartel to stop trying to support prices and it doesn’t have a damn thing to do with demand. If for whatever reason we go into a recession, then [people] are going to have to cut back on everything and that could include gasoline and everything that oil goes into. But considering that the oil price came into this 20 months ago at all-time highs adjusted for inflation, where it had been for five or six years and now is back to very normal ranges, why would we expect households and businesses to cut back on their use of energy as opposed to something else?
MT: Longer term you think low energy prices will be positive for economies.
DL: That is true; it is always true. But it’s nice to know why the prices are low. If the prices are low because of a technology breakthrough that suddenly makes oil more abundant and reliable then that is a really good thing. It is not such a good thing to have oil prices be as low as in 2008-09 because there is a global depression going on. It’s nice to have low oil prices, which help the economic activity get started, so even in that situation, low oil prices are good. But in the scenario we are in right now, low prices are good not because there is a banking crisis or a depression but because supply has been increased. That is good because it means that when economic activity starts accelerating again the oil prices aren’t going to go right back up to $130 like they did in 2010 and 2011 when we were looking at $32 oil in January of 2009. That was great, but you knew it wasn’t going to last. And it didn’t. So you couldn’t make any long-term plans on it. This is something that you can bank on.
MT: If low prices are so good, why is it causing a global slowdown?
DL: Low oil prices are a good thing; when they are associated with higher and more reliable supplies it’s doubly good, so what is the bad thing? Why is this causing a recession? The answer is, we have been in a bad situation for a very long time. Until a year ago, we had the highest inflation-adjusted oil prices in the history of the world for seven years. Even higher than when there were lines at gas stations in the 1970s. And it didn’t last seven years back then, it was a short, sharp shock and this just kept on grinding and grinding. What happens when you are in a permanent bad situation is you make lots of adaptations to it and one of the adaptations you make is you borrow billions of dollars [to finance] speculative [and] expensive experimental technologies like fracking, which are now proven. Nobody would be doing those experiments today with oil at $32 but with oil at $132 you could afford to do all that stuff and people did. And they borrowed the money to do it and they succeeded. In fact, they succeeded too well. Like a farmer who comes out of a season of scarcity and plants acres and acres of wheat and the next year he gets a bumper crop, [which] makes the price fall. If you produce too much, you bankrupt yourself and that is what happened here. So after approximately a decade of the world adapting to high oil prices in a variety of ways, all of a sudden that adaptation has become unnecessary and counterproductive, so all the people who borrowed money to adapt to that, who lent them money for them to adapt to that, all of the kingdoms and nations — countries like Russia that are just big oil companies organized as countries — they’re just screwed. They’ve got huge debts and deficits; this is a very destabilizing thing, even though it’s good.
A series of financial arrangements were made around this. For instance, in the non-investment grade bond market, 15% of the face value of the bonds that exist today are debts that are owed by frackers. That is $1 out of $6. There is a reason they call them junk bonds. Right now that is creating tremendous financial pressure throughout the banking system — there basically has not been any new issuance of non-investment grade bonds for about two and a half months because of the pressure coming out of a single sector. Earlier this week, Moody’s and S&P started downgrading some of the investment grade bond issuers like Chevron (CVX) and Conoco Phillips (COP). When that happens, it makes the cost of capital go up. That is precisely the same thing as if the Fed were raising interest rates. It makes financial conditions tighter and that causes recessions.
MT: You noted in 2015 that you expect crude to eventually return to a range of $15 to $40. Has your outlook sped up?
DL: My forecast was based on the idea that markets, especially commodity markets, fluctuate wildly. You get a lot of false moves, you get a lot of overshoot and that is what is happening with oil. We know as a matter of arithmetic that oil can’t be produced profitably at these prices, so production has already rolled over in the United States; it peaked in April — we are coming up on the first anniversary of peak oil production, for now, for this cycle — and when production slows down that means supply slows down and that means all else being equal the price starts moving back up. The oil prices just simply got it wrong, but over the long term, we are not talking about speculative noise but the physical reality of the ability to harness technology to make things happen.
It took 50 years to create the miniaturization in microchips. In oil it is not going to take 50 years, it will take another four or five until we acquire those skills and the knowledge of how to take fracking and apply it to challenging geologies like the shale layers in China, [which] don’t look like the shale layers in the United States. The U.S. is flat, China is very mountainous. In places like North Dakota, it is very easy to do horizontal drilling. In the case of China that shale layer is undulating up and down so you can’t have a horizontal pipe that runs through it. You would have to have a pipe that is somehow shaped like that shale formation. We don’t know how to do that yet. When we do, then there will be another reinvigorating round of oil production that will unlock reserves that we know are there as a matter of physics but they are not there as a matter of economics. Some day they will and that is when oil goes to $15 and never comes back, but we have to wait for that.
MT: Do you think we have a significant bottom in place?
DL: I do. But in all well-earned modesty. Oil bounced off $37ish a couple of times and then the Iran deal came out of nowhere. That unleashed a whole new world of unknown unknowns. Iran has very significant untapped oil reserves that would add new supply on top of new supply. How quickly can they do this? Can they get it together? Can foreign capital trust Iran and come in there and invest $100 billion in order to build out that capability, at these prices. I do think we hit the bottom at $26.19 on Jan. 20 but we should have respect for what we don’t know.
MT: But a bottom does not mean a return to very high prices as frackers could come back online, right?
DL: One of two things has to happen: Either the price has to go up or the cost of production has to go down. It takes time to get the technology better and experience and learning. If the price is low and you are cutting back on your production then you have less learning because you are not out there working on so many wells. [And] you can’t rule out geopolitical (shocks); right now the Saudis and Iran are bombing each other’s embassies. What if a missile goes wild and blows out a bunch of pipelines across the desert? Stuff can happen. Those are the Black Swann events that can happen in any market but particularly in one that is as infrastructure-intense as crude oil and one where so much of that infrastructure is in very dangerous parts of the world. You also can’t rule out overshoot.
MT: There is a lot of talk about discussions between Saudi Arabia and Russia. Is a deal possible?
DL: It is a possibility but this idea that OPEC is going to go back to its normal cartel ways [is unlikely], this is a rumor that has come out a couple of times over the last 20 months, and every time it does there is a rally like this and it turns out that it is not happening. It might happen, it might not. Russia is not a member of OPEC. It is hard enough to keep OPEC together among its official members, getting a country like Russia to cooperate is going to be even more difficult.
This narrative that they are trying to grab market share that started in November of 2015 with an OPEC press release, is trying to put a dignified front on what for them is a very desperate situation. They have gotten out of control. Because many OPEC members do have extremely low costs, they say if the price is going to collapse ‘we can handle it better than anybody else.’ But what is gained by that? If my market share increases by 1 or 2% but the price of your product falls by 70% in order to achieve it, I wouldn’t be strutting around like it is some great victory. Once you have market share, you can’t keep it. As soon as the price goes back up, with every penny the price goes up, there is somebody that comes into the market. What was the point in selling a year or two worth of your production at a 70% discount in order to achieve market share that only lasted while you were committing suicide?
MT: Who are the winners and losers?
DL: At this point it is financially driven. There are companies that have gotten way over-levered that are going to have to default on their financing and their assets will fall into the hands of somebody. So that tells you [who] the winners and losers are. The losers are the people that lose the assets; the winners are the people that buy the assets for pennies on the dollar. The natural buyers of these assets are the well-financed majors. There is probably a rough rule of thumb that little companies are bad, big companies are good.