Rough Economic Seas Toss Many Boats, Including Oil Price 27 comments
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The price of oil has been brought low by the collapsing global economy as we all know. What next? To see how far the economy may have to fall (and thus how long we can expect the oil price to be under pressure from reduced demand), let’s look at the bursting bubbles that are causing the economy to implode. They include a bubble in housing construction and housing prices; a bubble in financing - both stocks and credit expansion; and a bubble in executive compensation.
The first two bubbles have been extensively discussed and analyzed. Let me spend a minute on the executive compensation bubble since it rarely gets attention in the press and it has had huge impacts on the economy. Few economic commentators recognize that one driving force for U.S. economic growth has been outsized compensation, mostly of executives, with stock options that have floated upwards in value for many years. Stock option gains have pushed corporate compensation far higher than historical norms and I would argue, far out of line with the value of the work product of these people.
Stock options have gone from a fringe benefit for top management to a growing staple of executive compensation. It became an annual ritual for executives to give themselves new options. As the process evolved and as stocks rose nearly every year, executive would annually exercise the options that were profitable, sell their shares and then issue themselves new options. So if you looked at the record of insider purchases and sales of nearly all public companies there would constantly be slews of sellers and hardly any buyers. Who needed to buy shares of the company you work for when you are given options for free every year?
The net effect was that millions of people working for public companies have for years been pulling enormous sums of cash out of the public stocks of their companies, a cost that was never adequately reflected in the earnings of the companies or in any other way. Many tech companies, like Google (GOOG), for example, compensated virtually all their employees with options. In such cases, literally thousands of new millionaires were manufactured in the past decade. Perhaps such fortunes were warranted when truly world-changing companies like Google were built by hard working young people. But the greatest amount of stock option compensation was given to executives of ordinary companies that simply benefited from rising stock prices since 1982 based in part on the the rising credit, tech, and housing bubbles.
The poster child of excessive compensation was the $400 million option compensation for Rex Tillerson, the recently retired Chairman of Exxon (XOM). Tillerson may have run a tight ship, but it is questionable whether Exxon’s strategy of sticking with oil rather than developing alternative energy has been good for stockholders long term. In any case, Tillerson had nothing to do with the rise in oil prices that led to higher prices for Exxon shares and thereby allowed Tillerson to walk away with a king’s ransom of excessive compensation. What makes this a bubble is that Tillerson’s compensation is mirrored many thousands, probably millions, of times - usually but not always in lesser amounts - among “executives” of thousands of public companies.
What happened to all that cash? Some was consumed - vacations, cars, etc - and a lot of it was spent on first, second and third homes. Those homes had a multiplier effect on other industries - furnishings, white goods, developers, brokers and lawyers, advertising, etc. It created many sub-bubbles along with contributing to the bubble in housing prices. Sure, housing prices rose partly due to looser lending standards. But an important source was wildly excessive corporate compensation derived from stock options.
Now that the end of all these bubbles (housing, financing, stock option gains) has come simultaneously (because they were all related), the economy needs to fall to a level that is sustainable without such bubbles. How much of a fall is that? 5% of GDP? That seems easy. 10%? Perhaps. 20%? That seems too much. After all, we still have perfectly viable industries that will continue operating near the peak of their output: agriculture, education, medicine, law enforcement, food distribution, necessary housing, government, media, entertainment, transportation, technology. Much of that output is also valued in other parts of the world economy and so enjoys export demand.
Sure, many of these industries are slowing down. But they will not collapse like the worlds of finance, home construction, or luxury goods and services. In other words, as we step back from the economy and look at where it needs to contract, we see that it needs to contract primarily in the areas that were propelled by the wealthy class. Those are the folks who have been overcompensated for so many years, who have been overspending for so many years, and whose assets are in the process of contracting.
If the top 20% of U.S. economic activity generated by the wealthy needs to contract by, say, 25%, that’s only 5% of GDP. If that trickles down to the next 40% contracting by 5%, that gives us another 2%. And maybe we get a bit more from the non-consumer spending part of the economy. So it seems like an 8 - 10% decline in GDP would be more than adequate to get us to the level of a sustainable economy.
Shrinking the U.S. economy by 8 - 10% is a huge adjustment that will take a couple of years at the least to accomplish. Right now U.S. GDP is declining at a 5% annual rate. If we need two years of such a decline, that suggest we may start to bottom some time in 2010. That suggest that the price of oil might stay under pressure for a couple of more years in terms of demand declines.
But we don’t live in a static world. Clearly the Obama team thinks they can shortcut the downturn by exploding federal spending. That is going to have a catastrophic impact on the U.S. federal deficit. Moreover, the Fed has pushed short rates to zero and longer rates to not much more. Huge credit expansion along with wild deficit spending combined with a much weaker economy suggests that the U.S. dollar could come under great pressure at some point.
An extremely weak dollar, possibly over an extended time frame, has little precedent. The potential impacts of that are hard to predict but it would seem likely to have a major impact on the price of oil as expressed in dollars. Yes, there surely would still be an excessive amount of physical oil around during the next couple of years. But the number of dollars needed to be spent by Americans to outbid those able to pay for it in the more valuable Euros or Pounds or Renminbi would make the price of oil rise rapidly in dollar terms.
So I would suggest that a potential failure of the dollar could become a wild card in the projection of future oil prices. More important, it could be a wild card for the future of the U.S. economy. If anyone wants to refresh her emotional concerns about this, here’s a Ron Paul expostulation on the topic.
Absent a dollar crisis, it is hard for me to see a rising price for oil over the next couple of years, if it takes that long for the U.S. economy to grind its way out of the excesses of the past many years’ bubbles, not least of which has been the executive compensation bubble based on stock options. Other economies, particularly China’s, might recover more rapidly, but it seems doubtful that the global economy as a whole, and therefore demand for oil, will begin expanding again before the U.S. economy stops contracting. So the best near term hope for oil prices may be a falling dollar.
But a falling dollar, if sustained, could bring with it a host of other problems. So it is not totally clear that a rising price of oil as expressed in dollars would necessarily be good for the stock market or therefore for oil stocks. All in all, I still see no reason to own oil stocks at this time.
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This article has 27 comments:
The lesson from the 30's was: don't try to head off a recession by enacting a contractionary monetary policy.
The lesson from the 70's-early 80's was twofold: (1) just engineer a mild recession with double-digit interest rates if you need to kill high inflation and (2) don't let your economy become too dependent on petroleum.
Though we certainly didn't learn our lesson about petroleum dependency, the proper course of action in deflationary or inflationary environments is no longer controversial among economists thanks to hard-knocks experience.
Previous recoveries took years because government did the wrong things based on the wrong economic theories. This time, a historically tested plan is in place for both the deflationary and inflationary phases of the crisis. In other words, this time the initial recovery could arrive sooner than anyone expects. Look at how much wealth evaporated in the dot-com bubble and the nonetheless very brief recession that followed.
While I see recovery likely in the 1-2 year timeframe, 3-6 years from now we could be focused on cleaning up the consequences of our stimulus, such as inflation or another bubble (perhaps a currency, energy, or precious metals bubble).
Recovery in one to two years is likely but we need to readjust outlook every few months.
If you look at the many charts of debt growth, you see that the mid 80s was the take off point for the bubble and it also marks where the stock market turned skyward. If you draw an inflation adjusted line from this take off point through 2008, it shows we've pretty much returned to where the S&P 500 should be with a deleverage of the excess.
But this raises the question of how much of all the inflation over this period must be unwound with the debt unwind. After all, there was no commodity bull market to press prices up during most of these years, it was all paper inflation - stuff that doesn't hurt if it falls on your foot. But it sure hurts when it falls on all your paper belongings. So how much of the 20 year inflation was debt bubbled and should be unwound in the stock market? All of it? That would put the S&P 500 down to around 300!
In reality however, there were many other things fueling growth besides the artificial debt balloon - like the massive productivity revolution with technology invention, for example. So maybe our bear doesn't have to proceed from 750 all the way to 300 to undo the debt balloon and return us to the nice, simple, world of pre-1982.
<A HREF="www.questempire.com">QE</A>
No alternative energy sources will be developed with oil below $75.
Remember that China is a communist state capable of surviving and prospering under very adversed consequences.
"The lesson from the 30's was: don't try to head off a recession by enacting a contractionary monetary policy." - chrisb
I agree with this statement. However, I do not think there are many lessons to be learned from the depression if you believe it would have happened no matter what economic measures were taken. this is where i am standing today - i am not sure that any economic tools can prevent this economic event.
I think they have corrupted most of the CEO's in this country and
something should be done.
WHY ARE STOCK OPTIONS TAX FREE?
Sure 5 or 10 years down the road they may pay some tax
but the options HAVE REAL VALUE THE DAY THEY ARE GIVEN.
The Black Scholes formula gives a fair value of options.
People who get options should pay tax on them the quarter
they get them.
If they expire worthless later, the person can claim a long term
capital loss.
If anyone doubts the value of stock options, try buying some
with an expiration date just one year out.
You have more facts than top economist and analysts. Really stock options and higher corporate compensation are part of current bubble.
> jack
People will invent all sorts of schemes to satisfy greed. That is the original, fundamental bubble. JK is right.
The proportion of the gross income of an over-paid executive that goes into oil consumption is far lower than the corresponding proportion of the income of the long suffering (and radically growing) lower class in America. Taking away from management would actually stimulate demand and thus the economy.
perhaps skewed, unjustified compensation occurs at many sources. compensation advantages not shared by the majority of the public, but paid by THEM none the less.
help the public awareness with this topic. you have skills/perspective needed.
In the 30's through 90's, it took months to disseminate Economic news. The widespread use of the internet enabled the quick collapse of the Internet Bubble and the correspondingly short recession was because 9/11 allowed for multiple stimulus packages combined with low interest rates.
A combination of productivity gains and low labor costs due to illegals held down employment levels which in turn persuaded the Fed to keep interest rates down far longer than they should have been kept.
The result was a Housing Bubble. This Bubble was fostered by the Government's willingness to regrow the previous wealth loss via housing and the inability of Financial instutions of all stripes to grow earnings in a low interest rate environment. Refinancing promoted the use of derivates and the creative repackaging led to massive leveraging of the initial mortgages.
When the Housing Bubble started to slow, the impact of the 20-30 times leverages was not recognized immediately by outside regulators, heck, most of the regulators did not have a clue as to how interlinked everything was nor did they have any idea how much had been exported internationally. Meanwhile, Financial institutions started shoveling Toxic assets onto the Tier 3 level which allowed them to mask true value in violation of SarBox BTW.
One Domino after another, intervention after intervention until the Fed and Treasury drew a line in the sand and allowed Lehman to fail. With Lehman's failure, the worth of its Tier 3 assets was revealed. The Financial institutions probably confessed at that point which led to a quickly introduced "Bailout Package".
The Fed and Treasury probably could not have sold the idea to Congress under anything other than a Mortgage related rescue. Once passed, they quickly shifted gears.
The world was not as economically linked as they were in the past but in the Financial Sector, the US was still the Leader and they had followed our lead into the same pit. Since everything revolves around credit, credit implosions cratered everyone.
We are in a different sort of Bubble now. Risk Aversion is its name. Why buy low now when you will be able to buy lower later. It applies to products as well as Stocks.
A strong USD will continue to foster deflation in the US but will help the rest of the world undercut whatever we try to sell. $40 WTI is under $30 in Europe for instance, apply this differential to all commodities.
It cannot be allowed to start feeding on itself.
Hopefully, the arrival of Helicopter Ben will stop the Dollars rise. Otherwise what will follow? We are "saving" everyone now financially. Will Protectionism follow?
Hello new Great Depression.
IMHO
On Dec 19 10:50 PM Bill M wrote:
> Crude will test ~$20.00 before it comes back up
>
> <A href='www.questempire.com;>QE</A>
Nice article with real facts and written in plain english yet! Thanks
Merry Christmas and may your holiday what ever it is bring you joy and peace.
On Dec 20 01:54 PM notsosmart wrote:
> its all ponzi.the sheeples will keep on getting fleeced while they
> worry who will be in the superbowl.LOL
On Dec 20 11:08 AM fran wrote:
> please do a focus piece on gov't employee compensation[all levels
> of gov't]. as a population, this group is rewarded in salary,benefits,
> job security, longevity equal to or better than the castigated UAW.
> this group appears to be the single growth category in the nation.
> could this be a major cause of current gov't budget crises[fed, state,
> local]--as much as auto workers are to GM, F?
>
> perhaps skewed, unjustified compensation occurs at many sources.
> compensation advantages not shared by the majority of the public,
> but paid by THEM none the less.
>
> help the public awareness with this topic. you have skills/perspective
> needed.
Surviving yes - prospering no. China has survived for millennia but has only recently prospered after moving away from Mao's communist Cultural Revolution.
The next great crisis will be the unwinding of the dollar. Kingsdale has put his finger on the wildcard but he's not sure what the effects will be. We are in the midst of the fall of America as an economic leader and the dollar as the world's reserve currency.
Asean Zone, Gulf States, and even the Euro Zone are still in an expansion phases. Free Trade Agreements amongst resource rich countries abound.
The US and Russia still believe they can stand alone. The US, in particular, believes it can impose its values without consequence based only on its previous glory. Russia will use energy as a weapon when it can but still relies on its historical military might. Both of them Carry big sticks.
In the coming years, those countries which can change will be the next generation's leaders. Considering the makeup of Obama's Cabinet, the US will continue to live in the past. IMHO