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Here's Why the Oil Price No Longer Matters Lombardi Letter 2018-11-15 13:45:02 recession oil prices us economy interest rates federal reserve seven sisters OPEC saudi arabia shale oil market crash Contrary to what logic might suggest, there’s a good chance that the falling oil price will not stimulate demand, and could actually send the world economy into a recession. Analysis and Predictions 2018,Commodities,Global Economy,Inflation,News,Oil,Stock Market,Stock Market Crash,U.S. Dollar,U.S. Economy,U.S. Politics,World Politics https://www.lombardiletter.com/wp-content/uploads/2018/11/iStock-914983144-150x150.jpg

Here’s Why the Oil Price No Longer Matters

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Oil price doesn't matter

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A Low Oil Price No Longer Favors the Markets and Growth

It’s “damned if you do, damned if you don’t” when it comes to the oil price.

Contrary to what logic might suggest, there’s a good chance that the falling oil price will not stimulate demand and will instead send the world economy into a recession.

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Of course, a rising oil price would not solve the problem either. It would cause inflation, which, when coupled with rising interest rates, would also end up causing a recession.

Could the problem have more to do with the dollar then? After all, there’s a growing discrepancy between the current strength—or perception of strength—of the United States economy and comparative weakness in the rest of the world.

When the Oil Price Falls, Everyone Suffers

But according to economists, when oil prices fall, it’s not just the oil-producing Middle Eastern and African states that suffer.

Since the United States started to become an energy exporter, thanks to the shale revolution, there’s the perception that manufacturing economies also remain affected.

Therefore, investors and consumers—suggests the logic—lose confidence in a self-fulfilling prophecy that leads to lower demand.

If the world perceives that the Americans are consuming less, the entire global economy experiences a recession.

Yet, as hinted earlier, the oil price factor may have more to do with the relative strength of the U.S. economy over the others.

By comparison, in fact, the world economy is in a recession. And the root cause must be sought in the dollar.

Not so long ago—say, in the 1960s, 1970s, and 1980s—a low oil price was more than desirable. It was essential to the then-leading economic powers, rebuilding and growing after World War 2.

The Seven Sisters

If the West was rebuilding in every sense, oil was a resource largely produced in the Middle East and North Africa, even if the market was controlled by seven major multinationals, including the Anglo-Iranian Oil Company (now BP plc (NYSE:BP)), Royal Dutch Shell plc (NYSE:RDS), Texaco, and Standard Oil (now Exxon Mobil Corporation (NYSE:XOM)).

These companies controlled the price at which producing countries sold their oil.

There would be no Organization of the Petroleum Exporting Countries (OPEC) until 1960, and even that organization—which aimed to control the oil price to offer better returns to producing countries instead of the Seven Sisters—would not make its mark until the 1970s.

Those who threatened production or distribution, such as Egypt’s President Nasser when he shut down the Suez Canal in 1956, blocking access from the Red Sea to the Mediterranean, would soon learn the price of such conduct: a military invasion.

Such was the need for cheap oil that the West (namely the U.S. and the U.K. with a little help from France on occasion) conspired to overthrow governments that threatened to raise oil prices.

In 1953, for example, when a nationalist and democratically elected Iranian president nationalized Iran’s oil, a coup promptly removed him, replacing him with Shah Mohammad Reza Pahlavi—the very same who would be forced to flee Iran in 1979 during the Revolution.

OPEC Growls and Bites

The kicker came in 1973. Responding to the 1973 Arab-Israeli war, Saudi Arabia led other OPEC states to enforce an oil embargo against the West.

Oil prices rose sharply overnight and many gas stations went dry. Such was the scale of the OPEC revolt that cars changed radically. Americans learned to substitute economy cars and compacts for huge and torquey V8s.

The longer-term implication was that OPEC became a menacing organization, endowed with considerable “persuasive” power.

All good and powerful things come to an end. Texas shale oil has marked the end of OPEC’s overriding influence. And there’s Russian oil to contend with as well.

Moreover, the West’s economies are no longer the only game in town.

A Shift in the Oil Price Mechanism

The past few years, in particular, have transformed the classic formula of low oil price/strong economy that made recessions more predictable. It also made inflation more frequent and problematic from both producers’ and importers’ point of view.

Emerging markets, the very same that produce a huge concentration of natural resources, have grown tremendously in the past few decades economically and demographically.

These countries, once negligible in GDP-per-capita terms, now represent over 40% of the global economic output excluding China. If you include China, emerging markets account for almost 60% of global economic output. (Source: “Emerging Markets May Offer the Most Potential for the World’s Largest Consumer-Focused Companies,” S&P Global, August 3, 2016.)

In 1990, it was the reverse. The traditional economic powers or advanced/industrial economies like the Organisation for Economic Co-operation and Development (OECD) produced 65% of the world’s GDP.

Conversely, the United States has become much less dependent on Middle Eastern oil. The U.S. produced some 9.5 million barrels of oil in 2017. And it’s on the way to producing over 11 million by the end of 2018 according to the U.S. Energy Information Administration. (Source: “EIA,” U.S. Energy Information Administration, last accessed November 14, 2018.)

Therefore, cheap oil does not necessarily support economic growth. Overly high energy costs, however, do have an impact.

And that’s why President Trump expressed concern about OPEC production cuts last summer that led to prices rising significantly in October.

It No Longer Matters What the Saudis Say

The Saudis want to shut the taps again to flatten the oil price’s seasickness-inducing ride. But it will matter less now.

Rather, the Saudis can shut down some wells, but given the level of global dollar-denominated indebtedness, when U.S. interest rise, the same emerging markets that account for 60% of the global economy suffer considerably.

Therefore, it doesn’t matter how much oil costs, there’s simply less demand for it.

The combination of much lower corporate taxes and historically low interest rates—even if they’re rising—have overheated the U.S. economy and the dollar in comparison to the rest of the world.

Uncoordinated Central Banks

The central issue is that the world’s central banks—including the Federal Reserve—are not coordinated.

There’s no coherent global logic to interest rates, and the result is lopsided growth. There’s inflation, or the risk of it, in the United States, but low inflation in Europe and the risk of deflation elsewhere.

In this context, then, the markets interpret low oil prices as a sign of overall weaker demand rather than an opportunity for higher economic growth.

Like televangelists reading the coming signs of the apocalypse, interpreting current events in the context of scripture, investors and economists see the low oil price as a sign of the next stock market crash.

The End of the Cycle Has Arrived

They interpret the oil price’s struggle to settle, even after new and severe sanctions against Iran, with growing expectations that the bull market has approached the end of the proverbial cycle.

Indeed, the economy will slow down once the effects of the tax cuts wear off. The current bull market has lasted almost 10 years after a terrible recession, caused by the Lehman Brothers Holdings Inc.‘s implosion in 2008 and the shady financial mechanisms that produced it.

Should the oil price become a paradox, the allegedly heated labor market could soon prove a problem as well. If demand for American labor increases too fast, wages may rise beyond the economy’s ability to support them.

That will cut into profit margins and force equity prices down. And then, the higher interest rates will hurt all Americans’ pockets, given the unsustainable levels of personal, state, and federal debt.

Investors, the oil price is no longer a reliable barometer of economic sentiment or potential. It may be, however, a symptom of the end of one of the longest and strongest bull cycles in recent memory.

Editor’s Note: Hi,  Alessandro Bruno here. If you enjoyed this article, you can get more of my opinions and commentaries in our popular newsletter, Lombardi Letter. Published daily, it’s FREE! Join us when you click here now.

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