The Fed has presented the recent collapse in oil prices as an unambiguously positive development.
Sharply lower oil prices will boost spending and aid U.S. growth, said two of the Federal Reserve’s most influential officials, playing down the risk that plunging energy costs could push inflation further below the Fed’s goal.
Fed Vice Chairman Stanley Fischer and New York Fed President William C. Dudley, speaking at separate events yesterday in New York, both stressed the positive economic impact from the steepest decline in oil prices for five years.
“I’m not very worried,” Fischer told an audience at the Council on Foreign Relations. “The lower inflation that we’ll get from the lower price of oil is going to be temporary.”
He also said lower oil prices were “a phenomenon that’s making everybody better off.”
Although I understand their arguments, I think their heads are underwater.
The Fed is missing the massive role that US shale energy development has played in the recent US economic out performance versus the rest of the world. Since the recession trough, over 93% of the 10 million jobs created have been energy related. Have a look at this great chart from ZeroHedge:
The US economy has vastly outperformed most of the rest of the Western economies due to the unbelievable growth of shale energy.
US oil output has almost doubled in the space of less than half a dozen years. This growth is unbelievable. Have a look at this night time satellite shot of the Bakken shale area to get a sense of the scope of the development.
There is a belief that the US economy is outperforming the rest of the world because it is the “cleanest shirt in the dirty pile of laundry.” Well, the reality is that the shale energy boom is the driving factor in the US economic outperformance. Yes, Silicon Valley is booming, and there is no doubt that certain sectors that cater to the 0.01% are growing due to the absurd Federal Reserve balance sheet expansion, but these do not have the same sort of large economic impact as the shale energy boom.
And the really scary part of this whole shale energy boom is that it has been financed on the back of the Fed’s ultra easy monetary policy. I had been meaning to write this up for some time, as I have been worried that the next bubble might be in an area where market participants were least expecting it. The shale energy boom is the perfect candidate. But every time I thought about writing it up, I was presented with some sort of report about why the shale stocks were not in a bubble, and that everything was going to be just fine. I was too scared to take a position, or even write my ideas out loud. But isn’t that the way these things always go? In the mid 2000s when the real estate bubble was at its peak, anyone who dared suggest caution was a crackpot who just didn’t get it. My suspicion is that the shale energy boom is going to be exact same way.
When the Fed leaves rates too low for too long, you get mal-investment. This time not only have they left rates too low for too long, but they have actively expanded their balance sheet in a mad desperate scramble to create demand somewhere, anywhere. It will only be obvious in hindsight where the bubbles have occurred, but rest assured – there are going to be bubbles of epic proportion. Given the boom in the US shale energy during the last half dozen years, it makes sense that there is a very good chance that this lone source of economic prosperity has been taken too far.
My best guess is that we are going to experience years of US shale energy company defaults. There is most likely too much debt, based on too optimistic assumptions. Although I am a long term energy bull (based on growing Asian demand), barring a military conflict, I am not hopeful that prices are going to rebound materially in the coming months. These US energy companies have expanded too much, with too much debt. They are being squeezed, and will have no choice but to run the pumps full tilt.
Have a look at the US Energy High Yield Option Adjusted Spread (OAS) versus the entire high yield market.
The vast majority of the recent widening of credit spreads has been the result of the blowing out of energy credit. The bond market, which is always one step ahead of the equity market and even more ahead of Fed officials, has sniffed out the problems already.
Obviously the boom in the shale development is over. Now it is simply a matter of figuring out how bad the carnage is going to be. We are in essence at the stage where Warren Buffet described the tide as heading out and we find out who was swimming without bathing suits. My suspicion is that we are going to find that we were at a nudist beach and almost no one was wearing a suit. That is what happens when the Fed engages in the reckless behaviour of the last half dozen years.
The Saudis, whose recent moves were the catalyst that sent oil prices plummeting lower, are going to keep their foot on the neck of both the US and the Russians. Don’t expect them to lift up anytime soon. They want supply to be eliminated, and they are going to keep prices down here until it causes production to be cut back. The weakest members of the herd are going to be picked off.
Unfortunately, the Fed officials are clueless about what this means. Yes, at the margin the lower energy prices are beneficial to the consumer. But the 9.3 million jobs that have been created as the result of the energy boom are vastly more important.
I have not even spoken about the demand side of the equation. The fact that the oil price collapsed fairly suddenly was partly due to the fact of new supply coming on stream, but it is at least equally the result of collapsing demand. The global economy is decelerating at an alarming rate. Falling oil prices not only hurt the US economy, but they are also a symptom of the dangerous deflationary trend of the global economy.
So even though the Fed officials are putting a positive spin on the low oil prices, I think they are sorely mistaken in their analysis. Eventually, it might be a positive development, but over the coming quarters it is going to be a huge drag on the US economy. The Fed is clueless of the bubbles they created, and now that is popping, they are equally clueless about the ramifications.