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We Are So Not Prepared For Another Oil Shock

by John Rubino on June 15, 2014 · 18 comments

In one sense, energy doesn’t matter all that much to what’s coming. Once debt reaches a certain level, oil can be $10 a barrel or $200, and either way we’re in trouble.

But the cost of energy can still play a role in the timing and shape of the next financial crisis. The housing/derivatives bubble of 2006 -2008, for instance, might have gone on a while longer if oil hadn’t spiked to $140/bbl in 2007. And the subsequent recovery was probably expedited by oil plunging to $40 in 2008.

With the Middle East now lurching towards yet another major war, it’s easy to envision a supply disruption that sends oil back to its previous high or beyond. So the question becomes, what would that do to today’s hyper-leveraged global economy? Bad things, obviously. But before looking at them, let’s all get onto the same page with a quick explanation of why everyone seems so mad at everyone else over there:

The story begins in 570 A.D. in what is now Saudi Arabia, with the birth of a boy named Muhammad into a family of successful merchants. After having some adventures and marrying a rich widow, around the age of 40 he begins having visions and hearing voices which lead him to write a holy book called the Qur’an. More adventures follow, eventually producing a religious/political system called Islam that comes to dominate a large part of the local world.

In 632 Muhammad dies without naming a successor, creating a permanent fissure between the Shi’ites, who believe that only descendants of the Prophet Muhammad should run Islam, and the Sunnis, who want future leaders to be chosen by consensus.

Now fast forward to the end of World War I: British leader Winston Churchill sits down with some other old white guys to draw a series of rather arbitrary lines through the Middle Eastern territories recently captured from the Turkish Ottoman Empire. They name their creations Jordan, Syria, and Iraq and appoint kings to rule them. Unfortunately, the new borders enclose both Sunnis and Shi’ites, along with Kurds and Christians who don’t get along with either kind of Arab Muslim. Shortly thereafter, Israel is tossed into the mix and massive but unequally-distributed oil fields are discovered, pretty much guaranteeing instability for as far as the eye can see.

Since then, the Western powers have been trying to keep the oil flowing by periodically deposing/replacing leaders and making/breaking alliances. All without the slightest idea of what they’re doing. So the situation has gone from really bad in the 1960s and 1970s to potentially catastrophic today as various Middle Eastern dictatorships and terrorist groups plot to create a pan-Islamic “New Caliphate” while secretly developing weapons of mass destruction.

Which brings us to the present crisis: The US, having deposed Iraqi dictator Saddam Hussein and spent a trillion or so dollars trying to create a functioning democracy, has pulled out, only to see the new Shi’ite government oppress the Sunni minority into rebellion. With the help (or leadership, it’s not clear) of Syrian Islamists trained in that country’s ongoing civil war, the Sunnis are on the verge of taking over Iraq, and both the US and (Shi’ite) Iran are being pulled back in — apparently on the same side.

It’s a mess, in other words, and the flow of oil, of which Iraq and Iran produce a lot, is now threatened.

So what would $150/bbl oil mean today? Several things:

Another recession. The US economy contracted at an annual rate of about 2% in the first quarter and isn’t nearly as strong as analysts had predicted going forward. Let gas go to $5 a gallon, and the consumer spending on which the US economic model depends would dry up. Put another way, we might spend the same amount but it will be mostly for gas and not much else. So much for the recovery.

Equity bear market. Stock prices depend on corporate profits, which in turn depend on sales. If Americans buy less, corporations earn less. With blue chip equities currently priced for perfection, major companies faced with a sales slowdown will, if they want to keep their stock prices from tanking, have to borrow even more money and buy back even more shares, which will only work until interest costs start consuming what’s left of their profits. Then US stocks fall hard.

Currency crisis. If Saudi Arabia manages to stay out of this latest conflict, it will see its revenues surge as it sells the same amount of oil at higher prices. But it’s not happy with the US (something about us recently tilting towards Iran) and apparently no longer feels obligated to accept only dollars for its oil. Let it start accepting euros, yen and yuan, and the result will be lessened demand for dollars, a falling dollar exchange rate and all manner of turmoil in global bond markets.

Derivatives implosion. Derivatives — basically private bets on the behavior of interest rates, currency exchange rates and corporate bond defaults — on the books of major banks have actually increased in the five years since those instruments nearly destroyed the global financial system. There are between half a quadrillion and one quadrillion dollars face value of derivatives out there, and a spike in financial market volatility would cause a lot of them to blow up.

There are other possible consequences of a major Middle East war, but the preceding is enough to make the point that the more leveraged a system is, the more vulnerable it is to external shocks. And no one has ever been as leveraged as we are right now.

 

  • Bill Johns

    A great article. My only question is the potential for increased interest rates. There are lots of potential catalysts for a bear equity market, but I’d be very surprised if increasing short term interest rates were one of them. With the Fed on an edge, ZIRP and NIRP, and if every time anything potentially rattling in a geopolitical sense occurs, interest rates for the 10 & 30 year Treasuries drops, cheap money will be available for a good long time. Indeed, if there was a spike up in interest rates, a lot more folks than simply companies looking for cheap money for stock buy-backs would be impacted. Think of banks leveraged at 40+:1 or holdings of the Fed dropping in value. You’ll see Yellen doing back-flips in a tight, zebra-striped leotard before the FED increases rates. If the rest of the world starts dumping long term Treasuries driving those rates up, it won’t matter in any case.

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  • Bruce C

    This situation reminds me of the classic conundrum of probability theory: A particular outcome of any one “independent” event may have only the probability P, but the probability of that event NOT occurring after N “trials” is 1- P^N.

    How many potentially (“independent”) game-changing events in the last 6 years have not triggered an economic collapse? Each one seemed potentially catastrophic but also iffy. And yet each time some how, some way things worked out; consumers kept buying, the stock markets kept rising, interest rates kept falling, currencies stayed stable, and derivatives didn’t blow up. However, at some point statistics will rear its ugly head and it is equally possible that the “last straw” will be either an obvious one like an oil price spike or something so obscure and seemingly irrelevant that no one will have seen it coming.

    I’m excited. Personally, I’m willing to pay an extra $20 to $40 per tankful to see this monetary monstrosity finally go down.

    However, I will actually be surprised if oil prices rise much further, or at least gasoline prices. I still think that world events are still under control by elite authorities. I hope I’m wrong because I don’t like living a “Truman Show” existence, but I also won’t like it if this breaks the camel’s back.

    • Bruce C

      Correction: the probability of that event NOT occurring after N “trials” is P^N. (not 1- P^N)

      • peo

        (1-p)ⁿ

        • Bruce C

          Yes, thank you.

    • Bulldog007

      You live in the first world and I live in the third world. This means that a spike in the oil price would impact badly on us.

      I agree with you that each time a crisis occurs the masters of the universe come running out with their brand of (financial first) aid. This seems to work and the other side cries wolf (just like one Aesop’s fables). Eventually things will turn but no one can say when

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  • Antiehypocrite

    You have things totally backwards.

    HIGH PRICED OIL DESTROYS GROWTH

    According to the OECD Economics Department and the
    International Monetary Fund Research Department, a sustained $10 per barrel
    increase in oil prices from $25 to $35 would result in the OECD as a whole
    losing 0.4% of GDP in the first and second years of higher prices. http://www.iea.org/textbase/npsum/high_oil04sum.pdf

    Now if that is the case — then what do you think a sustained price over USD100 per barrel would do to growth?

    Here is a summary of things:

    In 2001 oil prices spiked from $12 in 98 to nearly $40…. obviously this is recessionary.

    What did the Fed do? They opened up the money tap and dropped rates to try to counter this collapsing growth.

    Of course this worked for awhile but it eventually this combined with $147 oil in 08 nearly blew up the global economy in 08.

    So what did the Fed do then as growth collapsed?

    Of course they went to Plan B – print money to try to counter the impact on growth of expensive oil.

    The high price of oil is the DISEASE – everything else we are experiencing are symptoms and attempts to fight the symptoms.

    The disease is fatal. There is no Plan C.

    When the next shoe drops there will be no recovery — the economy will blow into a million pieces — and civilization will collapse.

    The economy simply cannot function on expensive oil — and there are NO alternatives to oil — it is used in just about everything including the pesticides and fertilizers that grow our food.

    Enjoy life while you can — because for most people on the planet — it is going to end.

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