The Flying Frisby - money, markets and more Oil Broke the System
Never mind the dodgy mortgages, oil spiking to $150/barrel in July, 2008, just before the panic set in, was as big a cause of the Global Financial Crisis.
The price rise was like a sudden, unexpected liquidity drain on the economy. The US economy is built on oil. Costs suddenly rose across every supply chain. Disposable income was sucked out of households. Corporate margins got squeezed and inflation expectations rose effectively tightening financial conditions, just as the system needed liquidity. Funding costs then rose and collateral quality deteriorated. In a system already stretched with cheap credit and thin margins, highly leveraged institutions and ordinary borrowers were simultaneously pushed over the edge. The structure was fragile and it only worked in a low energy, low rate world. Subprime may have been the trigger, but the energy shock had already destabilised the foundations.
The oil price tightened financial conditions before central banks did
This is not a one-off
As Charlie Morris points out in his piece What Happened in 1974, there have been three major oil shocks - in 1973/4, 1980 and 2008.
In 1973 the US was dependent on Arab nations for most of its oil, and shortly after the Egypt-Syria alliance suddenly declared war on Israel, oil-producing Arab nations imposed an embargo on any nation that supported Israel. “You can support Israel or have cheap oil, but you can’t have both,” the Saudi Arabian king had said on US TV.
The oil price went from $3.50 to $10. It would eventually peak at $39.50 in 1980.
I was only a little boy in the 1970s but we lived in South Kensington and I remember how many Arabs suddenly moved to the area, many of them with a great deal of money. My step-father ran a business in Belgravia selling modern Italian furniture and his clientele changed almost overnight. Hundreds of billions of dollars, previously in Western bank accounts, now made their way to the Gulf in a transfer of wealth like no other. Next came the Rolls Royces, the racehorses, the Harrods shopping sprees (indeed Harrods itself), the mansions, the public school educations, the City petro-dollar recycling trade and yes the over-priced, glitzy, Valentino furniture. London would never be the same.
And what impact did those years have on bond and equity markets more generally? The 1970s were horrible, unless you were long commodities. The low reached in 1982 was so extreme that it marked one of the greatest long-term buying opportunities ever known, perhaps the greatest. While 2008 had its own consequences, not least the end of the City as a leading player in the global financial system (thanks to the regulation which followed), followed by the general decline of London.
Each of these episodes follows a similar pattern: an energy shock tightens conditions, exposes leverage and forces a reset.
It might not feel that way today with oil at $100, but we are still a long way from the extremes of 1974, 1980 or 2008. A lot of commentary is saying the investment world is too complacent and has not factored in what is coming.
What is 2008’s $150 oil in today’s money?
I’m not going to give you the CPI numbers because I consider CPI a bogus measure. Using money supply instead (M2), the equivalents look like this
* 1974: $10 oil ≈ $120-150
* 1980: $40 oil ≈ $360-440
* 2008: $150 oil ≈ $375-450
In the context of those extremes $100 oil does not look unreasonable
The sub-$60 prices with which we began this year now look extraordinarily cheap. I don’t think we are going back to them any time soon.
I’m also not saying we are going to those comparable numbers above. I merely show them for context.
In terms of where we are going, I think Charlie has it right when he says, “We should assume that $100 oil implies a slowdown, $150 a recession, and $200 a depression”.
$200 is not impossible if this was carries on.
What to do?
Let’s take a quick look at how to position ourselves, and at what’s in store for gold, silver, miners and the equities markets.
It was the right call to move into energy at the beginning of the year, I’m pleased to say. With such quick profits the temptation is to sell. I’m maintaining my positions.
The US, especially after the Venezuala episode, is self-sufficient in hydrocarbons. Europe is not. Whose oil and gas will it be buying now that Gulf supplies are in doubt, and Russian supply is off-limits?
Meanwhile, high energy prices make shale extraction profitable again.