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The everything pin

According to those who live in the world of finance, every bubble is in search of a pin.  The idea being that as the “smart money” moves into a particular asset, finance journalists take notice and spread the word.  Pretty soon, everyone with cash to spare has invested their savings in the asset; the price of which is driven upward by the rising demand.  The pin, in contrast, is some event in the real economy that forces investors to admit to themselves that the asset was overvalued; causing a rapid sell-off and a crash in the price.

We saw this play out in the 1990s and early 2000s, when the price of housing kept on rising.  By the early 2000s, working people’s houses were “earning” more than they were from working.  Economists were moved to proclaim the “Great Moderation” in which the economic woes of previous generations – unemployment, inflation, poverty, etc. – had been defeated.  In future we were to all benefit from permanently rising prosperity.

A combination of oil and interest rates converged after 2006 to burst the housing bubble and to snuff out the economists’ fantasy.  In the real world, a fall in global oil supply resulted in a big spike in the price of oil.  And since oil is involved in the manufacture and/or transportation of every item in the global economy, the prices of goods and services began to rise accordingly.  This was sufficient to slow the housing market, and was a particular risk to so-called sub-prime borrowers whose ability to repay was based on an already tight margin between their income and expenditure.  However, to add to their woes, central bankers – whose text books tell them to use interest rates to fight inflation – began to raise interest rates.  They were spectacularly successful; inflation disappeared overnight, and has not put in an appearance in a decade since.  In the real economy, however, the results were catastrophic.  Households and firms that had just about been servicing their debts in the face of rising prices were suddenly forced to find additional cash to meet higher debt repayment.  Inevitably people began to default.  Firms went bust and households began posting their keys back to the mortgage companies.  At which point, the world found out about the massive bubble in derivatives created by banks and sold into the murky world of “shadow banking.”

Most people assume that government regulators learned the lesson of 2008; and put new legislation in place to prevent a repeat.  However, this is only partially true.  A series of flimsy (and probably not worth counting on) internal “firewalls” were established between commercial and retail banking activities in order to protect the deposits of ordinary customers.  In addition, shareholders and large depositors are to be first in line to lose their money in the event of banks failing.  The shadow banking system which caused all of the trouble, however, has thrived.  As Pamela Yellen warns savers in a recent article for Entrepreneur:

“Shadow banks include all risky investment products and activities that flourish outside the reach of regulation. Think about those hedge funds, credit default swaps, collateralized debt obligations, and mortgage-backed securities (a/k/a derivatives) that triggered the subprime mortgage crisis.

“The list of Wall Street and banking villains is long, and their shady dealings have not gone away. Instead, they have morphed into new ways to skate around the rules which themselves were intended to prevent greed run amok from causing another collapse.”

There are plenty of zombie firms and zombie households just waiting for that one last price rise or interest rate hike to set off another cascading collapse of the kind we saw unfold in 2008.  Except, of course, this time around it will be an order of magnitude bigger as a result of the actions taken by central banks to prevent the collapse a decade ago.  Accounting for inflation, interest rates were close to zero in the UK, USA, EU and Japan for the best part of a decade.  At the same time, quantitative easing removed one of the safest assets – government bonds – from circulation in order to keep their prices high.  This left savers and investors with nowhere safe to run if they wanted their capital to keep up with inflation.  The result has been the creation of the “everything bubble” aka the “mother of all bubbles (MOAB)” in which a raft of asset classes from fine art to vintage cars to auto loans and sub-prime mortgages have been inflated, securitised and resold to a desperate investor class – including the managers of your pension funds and insurances – that needs to secure a rate of return well above inflation.

In 2018, there was some concern that central banks might be the pin that burst the bubble simply by raising interest rates for no other reason than that they have set an arbitrary five percent as the “normal” interest rate (as if anything can be considered normal in the post-2008 world).  In practice, even the attempt to reach two percent in the USA, one percent in the UK and 0.5 percent in the EU has raised the threat of a dangerous deflation as people’s spending power has fallen precipitously.  However, thus far a full-blown recession has not materialised, and central bankers have sounded more dovish; chastened, perhaps, by the damage that higher interest rates are doing to retail businesses.

Monetary policy alone is seldom sufficient to create the kind of cascading collapse seen in 2008.  More often it will be an event in the real world – which economists will call a “black swan” and claim nobody could have seen it coming – that will prove to be the pin that burst the bubble.  And if we were looking for a real world pin to burst an “everything bubble,” we could do a lot worse than to look for an “everything pin” – something that is intimately involved in almost all of the economic activity in our everyday lives; something that we could not escape even if we wanted to.

Oil was widely seen to be the culprit last time around.  However, most economists have ruled out oil this time around simply because of the vast amounts of shale oil coming out of the ground in the USA.  Lurid headlines appeared earlier this month claiming that the USA has become a “net oil exporter;” although, as Robert Rapier at Forbes points out, this is not strictly true.  In order to arrive at the figure, the reports had to count natural gas liquids and chemical feedstocks as “oil.”  Nevertheless, US production of both crude (which it still needs to import) and finished products has served to impact the global oil market; forcing OPEC and Russia to cut production in order to maintain prices.  It is highly unlikely that the world is going to witness oil shortages in the near future.

Not all oil is equal, however; and the US fracking boom appears to be obscuring a worrying trend within the oil industry.  Last month we reported concerns that the falling quality of oil on world markets together with new regulations designed to limit sulphur emissions from shipping threatened near-term shortages of diesel.  Reporting on these concerns, Steve St. Angelo at SRSrocco Report says that:

“I have heard from a few other sources that the refineries are indeed having difficulty in producing quality fuels from combining of tar sands and light-tight shale oil.  The industry thought by combining the heavy tar sands oil and U.S. light shale oil, it would make an average oil blend, similar to good ole fashion medium grade API conventional oil.

“However, it has turned out to be a real nightmare as this Tar Sands-Shale Oil blend creates a lot of difficulties for the refineries.”

The issue of the quality of US shale oil is also raised by Anas Alhajji in yesterday’s Financial Times:

“The world’s leading forecasting agencies have hailed shale’s tremendous growth as key to meeting oil demand in the coming decades. But by focusing on volume rather than quality, they are missing the point.

“Crude extracted from shale rock is generally far lighter than conventional oil and is not the type wanted by the world’s oil refiners as demand for heavier products such as diesel increases and demand for petrol decreases.”

Nor is this idle speculation.  Motorists have already seen a disparity between the prices of petrol (gasoline) and diesel at the pumps.  This gap looks set to widen considerably because of a growing disparity between the two fuels on global wholesale markets.  As Nick Cunningham at Oil Price reports:

“According to new data from the EIA, refining margins for motor gasoline have fallen to five-year lows. ‘Flattening year-over-year growth in gasoline demand in the United States, combined with high levels of refinery output, have contributed to low or negative motor gasoline refining margins for refiners along the East and Gulf Coasts,’ the EIA said on November 27…

“Meanwhile, prices for distillates, such as diesel, are much higher. The discrepancy is notable, and the markets for gasoline and distillates have diverged sharply this year…”

According to Cunningham, some of the discrepancy can be explained by a drop in US demand for petrol following high prices earlier this year.  However, it is not clear why this would only affect petrol.  Certainly the price disparity is what we would expect to see if the global oil market is being flooded with lighter products at the expense of heavy and medium fuels.  And this raises the possibility that we might experience a major oil crisis even as the world market is flooded with (light) oil.

The term “peak oil” was used to describe what would happen when the global oil industry reached and passed maximum output.  The expectation was that the global supply of oil would shrink, prices would go up and the economy would be forced to curtail non-energy activities.  In practice, following the global peak in conventional crude oil in 2005, we discovered that high prices cannot be sustained without triggering a recession.  Instead, investors have switched to producing short-term shale plays in preference to long-term conventional oil deposits.  Among its many negative consequences, this “fracking boom” appears to be forcing the supply of economically essential diesel down – and thus its price up – even as it is flooding the world with light oil products and chemical feedstocks.

Exactly how this plays out in the real economy is difficult to predict.  However, readers could do a lot worse than to read Alice Friedemann’s When Trucks Stop Running: Energy and the Future of Transportation.  Our roads are like the arteries of our civilisation; moving essential items (including the food we eat) and consumer goodies alike.  And while a handful of companies worldwide are playing around with prototype battery-powered semis with ranges of less than 100 miles between charges, there is simply no way of replacing the overwhelming majority of the trucks we depend upon; still less the heavy plant used in extractive industries and industrial agriculture that underpin the global economy.

The ubiquity of diesel-powered trucks and the global economy’s dependence upon them may result in their being the “everything pin” that finally bursts the “everything bubble;” whether next year or in 2020 when the new maritime rules come into force.  Either way, it is difficult to see how a real economy that has yet to recover from the 2008 crash will be able to cope with big rises in diesel prices that are bound (at least to begin with) to result in rising prices across the economy.  Nor should we overlook the propensity of central bankers and economists to do exactly the opposite of what is required and to raise interest rates further even as diesel prices are spiking.

If, however, the world really has passed “peak diesel,” then even if central bankers lower interest rates and engage in another round of currency printing, it is unlikely to be enough.  The global economy depends upon growth that is ultimately generated by diesel-powered machines and vehicles.  It can only collapse if the fuel that powers it can no longer be accessed.  And no amount of government bond-buying and helicopter money (still less windmills and solar panels) is going to change that.

As you made it to the end…

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