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Be careful what you wish for

Recession was expected to follow when oil prices spiked up to $80 per barrel earlier this year.  Instead, increased output from Saudi Arabia and a series of exemptions for countries importing Iranian oil have helped prices fall back to a less recessionary $50 per barrel.

In response, US President Trump tweeted out his thanks to Saudi Arabia, saying that the cut in price was: “Like a big tax cut for America.”  This is unsurprising, since it reflects conventional economic thinking over decades.  Oil prices rise and we little people have to cut back our spending elsewhere in the economy.  In the same way, if we have to spend less on fuel, we have more to spend elsewhere… and that has to be good for the economy, right?

Not according to Brendan Greeley at the Financial Times:

“Cheap oil is still great for American drivers. But it also discourages American oil firms from drilling new wells in West Texas shale. What Mr Trump does not seem to have grasped is that the country doesn’t respond to the price of oil the way it did even a decade ago. Sad drillers now have a bigger effect than happy motorists…

“Usually, consumption makes up the biggest contribution to growth in the US. It is a developed economy, full of people who buy stuff. For several years after the last recession, though, consumption growth gave way to private non-residential fixed investment — businesses buying new plants and machines. Then, around 2015, people began buying stuff again. But businesses stopped doing so.”

These are the findings of a new paper by Nida Çakır Melek from the Kansas City Fed, which points to a radical change in the way oil prices operate on the wider economy following the growth of US shale oil after 2005.  They are also in line with the thoughts of peak oil theorists like Richard Heinberg and Gail Tverberg, who argue that following peak conventional oil production in 2005, the oil market broke out of the “Goldilocks zone” in which oil producers can make a profit without triggering a recession.

Prior to 2005, new investment was most responsive to oil supply shocks.  Today, investment is driven by highly volatile demand shocks of the kind that saw the oil price drop from above $100 per barrel to less than $35 per barrel between 2014 and 2016.  Nor is this limited to oil industry investment.  The oil industry is now a large enough player in the US to impact capital investment across the entire economy.  As Greeley notes:

“As Mr Trump thanked the Saudis on Twitter for the price of oil, he closed with a plea: ‘Let’s go lower!’ West Texas Intermediate was around $55 a barrel. That’s roughly $5 above the new break-even — the level at which the price of oil starts to drag on business investment. Mr Trump is stuck in the early 2000s, when American presidents just needed the Saudis to make driving cheap. But he has the same problem of any other oil state. He also needs oil just expensive enough to keep frackers fracking.”

For political reasons, of course, Mr Trump needs to keep the motoring public happy.  But that short-term expedient may well result in bankruptcy across the highly-leveraged (some would say Ponzi-financed) fracking industry.  And when that bubble bursts, it could well take the global banking system down with it.

As you made it to the end…

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