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Oil Prices, The Chase For Yield And Another Roll Of The Dice

China, Company Strategy, Economics, Europe, Oil & Gas, US
By John Richardson on 03-Jun-2015

By John Richardson

casino_crapsGILLIAN Tett, the outstanding financial journalist, talked about “silo thinking” in her book – Fool’s Gold – that detailed the root causes of the Global Financial Crisis.

By this she meant how too many people only had deep knowledge of one particular aspect of how financial markets were supposed to work – for example, the arcane theoretical models that were meant to predict how the pricing of credit default swaps would always behave.

She also contended that there were far too few people who could see the links between all the different aspects of financial markets and the wider economy, who could look up from their Excel spreadsheets and realise that people make data and so understand that the behaviour of numbers is shaped by human beings.

I wish central bankers in the US and Europe had read and taken on board Tett’s message. If this were the case, we then might not be living in the “Alice In Wonderland” world described by Claire Jones in this Financial Times article:

Stashing cash in secret vaults is the sort of activity usually associated with criminals. Now Swiss pension funds are considering getting in on the act. The reason is that they are fed up with having to pay banks simply to park their money in regular accounts and are considering making mass withdrawals.

Welcome to the Alice in Wonderland world of negative interest rates, a topsy-turvy universe where central bankers are so alarmed at the prospect of weak inflation that they have cut borrowing costs below zero, in effect charging financial institutions to leave their accounts in the black.  

The Fed and the European Central Bank hope that by keeping interest rates at record lows – in fact, now in negative territory – this will encourage banks to lend money to productive, useful businesses.

But the central bankers are failing to spot the link, the root cause, of why after seven years of huge monetary stimulus, banks and other investors are still very reluctant to lend to useful businesses: There isn’t enough real demand out there. And why isn’t there enough real demand in the real economy? Because of ageing populations in the West.

So we end up with pension funds and other investors either stashing their money in bank vaults or chasing higher yields – actually, any kind of yield at all – in very risky and highly volatile investments.

Take shale oil and shale gas as very good examples. First of all, we saw $1.2 trillion invested in the US energy sector in the space of just five years as investors chased yield. This led to vast oversupply of oil that resulted in last year’s collapse in crude prices.

And now investors, still desperate for some kind of returns, continue to pour money into what on paper should be severely financially distressed shale-oil producers. For example, the Wall Street Journal writes that:

Wall Street’s generous supply of funds to US oil drillers helped create the American energy boom. Now that same access to easy money is keeping them going, despite oil prices that are languishing around $60 a barrel.

The flow of money into oil has allowed US companies to avoid liquidity problems and kept American crude production from falling sharply. Even though more than half of the rigs that were drilling new wells in September have been banished to storage yards, in mid-May nearly 9.6 million barrels of oil a day were pumped across the country, the highest level since 1970, according to the most recent federal data.

The hedge funds, the pension funds and the private-equity players that are pouring more money into shale oil are, of course, hoping that this will pay off through a big oil-price recovery.

You can, if you live in a silo world, also see the logic of this from the performance of energy stocks. As the Journal adds:

Energy shares are lagging behind the overall stock market. Over the past year, the S&P 500 is up 9.6%, but energy stocks in the index are down 17.6%. Some investors, betting on an oil price rebound, regard energy stocks as a relative bargain.

But we know that OPEC is likely to maintain high production levels at its June 5 meeting.

We also know that the “wild card”, Iran, could significantly add to global oversupply of oil if it reaches a nuclear deal with the West on by the June 30 deadline.

We should also know that as populations continue to age in the West – and as China’s economy slows down even further due to a radical and highly risky economic reform programme – oil and energy in general will remain oversupplied. Again, the demand will simply not be there to support oil prices anywhere close to their levels of H1 last year. We have entered an era of abundant and cheap energy in general – because of demand as well as supply.

And let’s widen this out to investments in all the risky assets that have been driven by record-low interest rates including in global equities and bonds, in other industries such as information technology and overall mergers and acquisitions activity. Hand on heart, can every investor honestly say that the majority of deals that she or he has done over the last seven year has been down to a calm, rational analysis of the long-term fundamentals rather than just the chase for yield? Of course not.

How might this play out? As I have been warning for more than a year now, we are at risk of a repeat of 2008. What might the trigger be for this new global financial crisis? As Claire Jones of the FT once again writes:

Central bankers hope that low inflation does not become so entrenched that the public becomes more willing to accept charges on their savings.

Sadly, I think we are already at, or very close, to this point as we enter a period of global deflation. As prices for everything continue to fall, investors who felt compelled to chase yield will start losing a lot of money. And when that happens, we could end up with another panicky “fire sale” of assets that was, of course, behind what happened in 2008.