Oil Price Plunge Is Deflationary Canary In Coal Mine

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Includes: CAT, COP, DE, DNR, NUE, OAS, TGT, WMT, X
by: ModernMonetaryTheorist

Summary

The sudden plunge in oil prices could lead to a deflationary shock throughout the economy.

Like the 1930's, once a broad deflationary mindset takes hold it can be very difficult to change.

The Federal Reserve has ended quantitative easing prematurely and should restart the program.

The price of oil has experienced a sudden and sharp drop. Both the Brent Crude and West Texas Intermediate oil benchmarks have fallen from $105 in July to the upper $50's in December of 2014. The slide continues and it is unclear where and when oil prices will stabilize. Many economists have touted this as a positive for broad parts of the U.S. Economy. But the speed and magnitude of the price decline risks deflation spilling over into other parts of the economy.

Already multiple oil companies like ConocoPhillips (NYSE:COP), Oasis Petroleum (NYSE:OAS), and Denbury Resources (NYSE:DNR) have announced large capital expenditure cuts for 2015. For example, ConocoPhillips (COP) has announced a 2015 capital expenditure budget of $13.5 billion, which is a 20% reduction from 2014 levels. Oasis Petroleum (OAS) announced plans to cut its 2015 capital budget in half versus 2014. Denbury Resources (DNR) has also announced a 50% cut in 2015 capital expenditures. Many other companies have, or will, announce large cuts of their own.

These spending cuts will impact the revenue of multiple industries that on the surface are not seen as tied to oil. For example, the reduction in drilling will also mean a reduction in pipes to pump out and ship the oil. This will hit steel companies like U.S. Steel (NYSE:X) and Nucor (NYSE:NUE). Many oil wells are drilled in remote areas that require new roads. This will hit large equipment manufacturers like Caterpillar (NYSE:CAT) and John Deere (NYSE:DE). Workers in the oil industries are some of the highest paid blue collar workers in the U.S. As jobs are cut, and wages are cut, communities relying on oil workers to spend money will be hit hard as well.

From agriculture to retailing, a reduction in fuel costs will lower transportation costs across the whole economy. Companies like Walmart (NYSE:WMT) and Target (NYSE:TGT) are part trucking businesses. While this allows for the potential of enhanced profits for these industries, it also allows for price reductions. Consumers may soon anticipate price reductions some where besides just the gas pump. And they are likely to get it. This could create a deflationary mind set that, once reinforced, can be very difficult to overcome. In the 1930's the U.S. experienced broad and persistent deflation. It was only the onset of World War II that shocked the economy out of deflationary expectations. Likewise, Japan has had deflationary expectations since the early 1990's. The Bank of Japan has still not eradicated those expectations from their economy.

Deflation is already starting to show up in some of the economic data. November export prices fell 1% and November import prices fell 1.5%. This data was collected before the Black Friday after Thanksgiving collapse of oil prices. Here is the take on the data from Bloomberg

"Cross-border price pressures are nowhere to be found in the import & export price report where import prices dropped 1.5 percent in November, the 5th straight drop and the steepest since June 2012, and export prices fell 1.0 percent for the 4th straight drop and matching the steepest drop since June 2012. The year-on-year rate for import prices is at minus 2.3, the steepest negative reading since April 2013, with export prices at minus 1.9, the steepest since October 2013."

In October, the Federal Reserve announced they have ended quantitative easing. They will no longer enter the markets and purchase federally backed bonds to expand their balance sheet. They did say they plan to keep their balance sheet level for now. This is a major mistake. The Federal Reserve is focusing on employment data, which is a lagging indicator. The data is also horribly skewed because so many people have been removed from the workforce. The New York Times has a report on men in their prime work ages of 25 to 54. In 2000, there were 11 out of 100 men in this age group out of the labor force. Today, there are 16 in 100 men out of the labor force. The unemployment rate is only based on people in the workforce.

Oil is not only a physical asset, but a financial asset. It is far and away the most traded commodity in the world. According to the CME Group, average daily trading volume on their exchanges for light sweet crude oil averaged $55 billion worth of contracts per trading day in November. The second most traded commodity is gold. According to the CME Group, average daily trading for gold in November averaged only $18 billion in comparison. The liquidity in the oil market is currently three times greater than the liquidity in the gold market. This means it is easier for larger amounts of money to move in and out of the oil market than it is to move in and out of the gold market. While many have rightfully focused on excess oil supply and the moves of OPEC to explain the recent plunge in oil prices, they should also consider the role of the Federal Reserve's decision to end quantitative easing as a contributing factor.

The last time oil had a dramatic sell-off was in the summer of 2008 through the winter of 2009. Oil fell from a high of $145 per barrel to a low of $32 per barrel. During the same timeframe the global financial markets collapsed after Lehman Brothers declared bankruptcy in September of 2008. The price action during that time showed oil prices could act as a financial asset in addition to a physical asset driven by supply and demand and the actions of OPEC. Oil prices only began to rebound when the Federal Government and the Federal Reserve took actions, including quantitative easing, to restore confidence in financial assets.

The current sell-off in oil is not following other financial markets. But the slide in prices correlates with the release of the Federal Open Market Committee's Minutes in July of 2014. Bloomberg reported that those minutes indicated "...that taper is on schedule and likely will end in October if the economy follows the Fed's forecast." The sell-off accelerated in October after the Federal Reserve announced it had ended the current round of asset purchases. Perhaps this time oil is acting as a leading indicator for other financial assets. Other financial assets may still need the support of quantitative easing from the Federal Reserve. If this is the case, then the sell-off in oil should move into other financial markets like high yield bonds and stocks.

The Federal Reserve has been consistently behind the eight ball since the Great Recession (Depression) started. They have already ended quantitative easing programs only to have to revive them. Once again they have ended quantitative easing too soon and have sent the wrong signals to the market. If a hard asset like oil can fall this fast, so too can other hard assets and financial assets. The purpose of quantitative easing is to stabilize and raise asset prices, thereby creating a wealth effect that encourages spending. The plunge in oil prices is the deflationary canary in the coal mine. The solution is for the Federal Reserve to announce a new round of quantitative easing, and soon.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.