The True Cause of Recessions: High Oil Prices

by: Glen Bradford

The premise to this argument starts with a question: Is it a coincidence that recessions tend to begin with oil price spikes? I don't think so. I think that the two go hand in hand. If you don't believe me, take a look at the graph below and let's get started.

Oil Broke the U.S. in 2008:
In 2008, the global financial markets had been pricing homes at unsustainably low interest rates that for the most part didn't factor in the risk of default because the underlying assumption was that home prices would never fall. For the distance commuters outside of major cities in the land of suburbia, the short-term doubling of gas prices started to erode their near zero daily profit margins, which were already being financed by faulty assumptions. The people hit the worst were the ones 15-45 minutes outside of larger cities -- the commuters. When these commuters were forced to choose between driving to their job and their mortgage payment, they chose to keep their job. Demand for various goods and services started collapsing and that was the crash of 2008.

Oil to Break the World in Next 12 months:
The latest last ditch effort to flood the market with oil in my opinion illustrates the current tightness in the oil supply as well as the blind ignorance of the people who think they can beat oil speculators. I'm of the opinion that there is a point that we are heading towards where bailouts on a per annum basis are larger than global GDP. You could call it "big government." The bottom line is that it is very likely that we get an oil price spike before any of this other stuff comes to fruition, and this price spike cripples a few bailout plans and forces countries with junk bond ratings to choose between importing oil or paying their minimum installments. Granted that it is impossible for them to ever pay off their debt at this point in time, I can assure you that they will choose oil over interest payments. The net result is a a domino-like euro-zone default contagion. Assuming that as relative purchasing power evaporates that oil prices come down, we'll see the tide go out and China will be the emperor that has no clothes, Australia's housing bubble will pop and cash will be king.

(Click to enlarge)

The Economic Backdrop:
Warren Buffett has noted that the politicians are effectively playing russian roulette with the U.S. budget, but to the best of my knowledge, he hasn't done an adequete job of understanding the source of the budget deficit. Everything was planned and budgeted with low oil prices and shorter than realistic life expectancies. That's just the USA. Globally, Australia and China are real estate bubbles and Europe is facing a poorly structured sovern debt collapse that actually will have serious reprocussions in terms of net global demand for goods and services. What's going to put it over the edge? Italy is on deck. I don't know how people can discount company cash flows and say that the stock market is undervalued when a lot of these profits are riding on the backs of what would have to be progressively larger future government bailouts.

What You Can Do:
Frankly, as many people continue to hate the U.S. dollar, it's going to be a net beneficiary of this aftermath. I don't particularly see the need for the U.S. to balance its budget. I'm a MMTer. Oil prices have a tendency to come down after the damage has been sowed. What's crazy about this particular case in history is that peak oil might stifle any hope of a recovery. Until then, the current global financial situation continues to hinge on the USA running a large deficit. Raising cash isn't a terrible idea. Buying real estate in multi-family dwellings in the middle of big cities and renting them out is probably a winning strategy. Avoid anything that has a large portion of its future discounted cash flows derived from the globalization of commodity trading, which is mostly commodity hoarding and unsustainable leveraging in China. The euro is a good short, and I'm a fan of the yuan being overvalued as well. When things look unsustainable, caution is warranted.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.