|From Gately's "Lessons from the 1986 Oil Price Collapse"|
Gately's chart plots output, price, and revenue on a graphical space that can be pictured as a curve in three-dimensional space, but, for informational purposes, it relies on level curves to make its point. The display is also set up to reflect the structure of a standard supply and demand graph with price on the y-axis and output on the x-axis, and this allows us to theorize about an equilibrium if the data provides some structure to the behavior of the market. Because OPEC acts as a cartel with quasi-monopolistic powers, plotting its output alone is sufficient.
At first glance, I noticed that the behavior of the OPEC output movement appeared cyclical from 1970 to 1986. With the exception of a kink in the late 1970's, the trend in the market appears to mirror a positive feedback loop in which price and OPEC output respond to each other's movement with revenue level accelerating the shifts. As prices grew from 1973 to 1974, OPEC kept output levels high to take advantage of higher revenue. In 1980, prices peaked after the global supply of oil had grown from the growth of production in North America and OPEC. In response, the cartel attempted to cut production to cushion the fall to a low in 1986. Prices would bottom out later that decade and, encouraged by low revenue levels, OPEC would add to output in anticipation of a higher equilibrium price. Saudi Arabia's data reflects the same kind of trend but with more inelastic output changes. From 1970-1973 and 1980-1985, the Middle Eastern nation had the most flexibility in its output policy. The years following the shifts in production were defined by dramatic moves in price suggesting that OPEC's swing producer had an enormous amount of control over the pricing mechanism. Although, is was still susceptible to the cyclical trend because its government relied on oil revenues to keep the country operating.
But 1986 is history, and if one reads more and more about the behavior of 20th century OPEC, it becomes quite predictable amidst the countless number of regional conflicts and price control tactics. Using the behavior in this period as a predictor of what should or could happen in the most recent oil glut of 2014-2015 has proven to be useless. This is most likely caused by the growth of non-OPEC supply, particularly the North American shale producers. Nevertheless, OPEC actions still have some effects on the markets, but, overall, the effects are muted. To investigate the fundamental picture, I recreated the chart above to track the movement of price and output in relation to revenue from 2000-2015 using Gately's style.
Based on price data from OPEC's Statistical Review adjusted for inflation and exchange rates and daily output figures from the Monthly Oil Market Reports, I was able to map the two series over some revenue isoquants calculated by multiplying price and output together. The behavior that is observed between 2000-2016 is very different from that of 1970-1986 with a circular figure turning into a curve that appears to trend linearly over time (as shown by the purple trendline). We have a gradual increase in OPEC output accompanied by a quasi-proportional increase in the price of oil up until 2008. The financial crisis occurs producing a slight deviation from the trend which reaches its peak, in both price and output, in 2012. Based on a linear regression analysis, we can develop a theoretical supply function that appears to define OPEC price policy from 2000-2012. So have we observed a deviation from the monopolistic behavior we saw in the previous graph? Not exactly.
The oil cartel is taking advantage of the inelastic qualities of petroleum demand to secure the best price for each barrel they produce. Because OPEC member nations need to reach these higher revenue levels to support the growing costs of government and higher rates of inflation in the 2000's, they seek to optimize policy to be as far right on the supply function as possible. In order to do this, OPEC made use of the regional conflict in Iraq and demand growth in emerging economies to achieve its goal, but there would be residual consequences. Remember how higher revenue levels would accelerate the trend in the opposite direction as producers seek to maximize output to reach even higher revenue levels? Well, the trend of price leading up to 2012 sparked a new set of producers to optimize and, in the end, flourish. North American shale producers reaching untapped reserves and pumping them quickly challenged OPEC for its market share causing the green line to drop to where the awkward looking 2015 data point falls. Here, the market has changed as OPEC's monopolistic powers are threatened by this surging source of output. This new competition can be modeled by a shifting of the purple supply curve so that to intersects the 2015 data point. The oil cartel now has less control over its revenue streams.
The new pricing mechanism in the current market will not allow a trend like that of the early 2000's to develop. For that reason, OPEC has been wary in trying to influence the market with an output freeze (or an outright cut). While that cut in the 1970's would have supported price, one in 2016 would be met by an increase in North American shale output. Saudi Arabia hinted at this shift in power when it announced a sale of 5 percent of Aramco stake in the U.S. markets with the goal of financing an investment fund that would reduce the country's reliance on fossil fuel income in the long run. Suddenly, OPEC looks useless despite calls for action by investors have suggested otherwise. At the moment, only a Saudi Arabian-Russian agreement looks to have any major effect on the price of oil, but based on economic circumstances in both countries, neither can risk a drop in output being negated by an increase in North American production. In the end, I see OPEC countries being forced to come to terms with a new oil market. After all, renewable energy is getting cheap, and there is clearly a global preference for those energy sources.
Sunday, November 13, 2016
While doing some research for my book earlier this month, I came across an interesting graphic created by Dermot Gately in his paper "Lessons from the 1986 Oil Price Collapse." The chart provided a useful perspective on the equilibrium price of a barrel of oil during a period where OPEC sought to control the price by cutting production after it fell to lows in the 1970's. Revenue levels for the oil cartel declined to almost $50 billion endangering the health of many economies that relied on its natural resources for survival. As more members began to feel the pain of tighter trade balances, more support for a supply cut forced the hand of the swing producer, Saudi Arabia. The price control worked until 1986 when prices crashed again.
Friday, November 4, 2016
The steadfast Federal Reserve is at it again. After a meeting on November 2nd, the committee of ten concluded with the federal funds rate and the discount rate held steady at the status quo. In the release, they say that “the case for an increase in the federal funds rate has continued to strengthen,” but of course, confidence wasn’t strong enough for the economy to off of low-interest rate life support. Three hesitant words stuck out to in particular: the labor market is expected to “strengthen somewhat further,” economic activity well grow “at a moderate pace,” and market risks “appear roughly balanced.” To me, these filler words indicate that the Federal Reserve recognizes the signs of a cyclical peak and seeks to diffuse tension in an economy that is moving flatly. The S&P 500, Dow Jones Industrial Average, and Nasdaq indices are trending at all-time highs, valuations continue to rise, and economic numbers paint an ambivalent picture of the economy. It’s not hard to conclude that we’re reaching a cyclical top after considering the fact that a seven-year bull market has pushed us to this top.
During a bull market, central banks typically raise interest rates to keep in check a rising level of inflation, but the Great Recession lead to a recovery that suggested typical monetary policy should be abandoned. Instead, policies like global quantitative easing and cheap debt were held in place to support a recovery. A divergent strategy has forced the Federal Reserve, along with the rest of the world’s central banks, into uncharted waters where it elected to keep the status quo. Companies liked that, but weird things started happening with inflation. An oil price shock caused half the world to develop symptoms of deflation, and rate hikes in this scenario would only hurt world markets.
Needless to say, the Federal Reserve finds itself in a very “un-normal” position where it must protect investors from a bubble while also shielding the economy from deflationary pains. In order to do this, the FOMC committee has elected to move in the direction of a “normalization” policy. When I first heard this term from one of the Fed member’s speeches, I just assumed “normalization” meant “rate hike,” but there is a distinction between the two that the Fed has intentionally signaled. While both involve increasing interest rates, a rate hike policy has a bearish connotation that suggests an abrupt shift in rates while normalization implies a more neutral move towards a clear target indicated by the central bank.
The key driver of the use of “normalization” language is the lapse in the recovery of inflation after the Great Recession. The chart above shows how a series of three periods of quantitative easing lead to a decline in the inflation rate from 3.77% annually in 2011 to -0.20% in early 2015. The FOMC first signaled that inflation was not where it wanted to be in the release following the December 2012 meeting by saying, “Inflation has been running somewhat below the Committee’s long-run objective.” Ever since then, the issue of inflation has risen to the top of the Fed’s list of priorities and has consistently been the reason why rates were held low. “Normalization” is the “solution” to this problem of nagging deflationary pressures, and I say “solution” carefully because this policy only works if markets respond the right way.
As evidenced by USD and Treasury yield movements at the conclusion of an FOMC meeting, investors like to jump the gun when it comes to reacting to a monetary policy updates. Normalization seeks to avoid the volatility associated with these movements, so the Fed acts in an extremely slow manner. In fact, they will set medium-term plans for the next three year and purposely act slower than what they projected. For example, projections from the December 2015 meeting suggested that four rate hikes would be a plausible way to move forward in 2016. Seven out of eight meetings later, the Fed has yet to raise even rates even once. In doing this, the Federal Reserve is manipulating expectations so that investors trade like four rate hikes are in play. When the meetings actually do come around, expectations are gradually dropped and the markets perceive the lack of rate hikes as accommodative policy. When rates are increased in December 2016, the markets’ reaction shouldn’t be decisively bearish. “Rate hike” policy suggests that markets should expect a rise in interest rates, and the Federal Reserve will follow through on these intentions. This distinction is necessary if a 2 percent inflation target is to hold any legitimacy. Only through normalization policy could the Federal Reserve massage inflation rates to their liking; a clear rate hike agenda is deflationary and would yield different results.
An agenda that is contractionary on purpose would be very dangerous in the current global monetary condition where central banks across developed and emerging economies have failed to move in a coordinated manner. The BIS released the charts above showing how central banks have been forced to respond to local inflationary effects. In Europe and Japan, negative yields have been introduced to combat stagnate growth and deflation while developing countries like Brazil, Colombia, South Africa, and India have set rates higher to tame inflation rates above the respective bank’s inflation target. This environment differs drastically with the coordination that was required to repair the damage of the financial crisis. If the Federal Reserve chooses a “rate hike” policy which could upset measures being taken in countries troubled by deflation, it could send negative shockwaves in the foreign exchange and capital markets. Adopting “normalization” would put the Federal Reserve more in line with foreign central banks who are attempting their own forms of careful normalization, and consequently, would calm volatility in equity and bond markets that is being caused by shifting investor expectations.
The Federal Reserve has shown its preference for normalization policy by choosing the appropriate signaling and maintaining global monetary coordination. Going forward, the Fed will deviate farther from rate hike policy by ensuring that the differences in timing are evident. In May 2015, BBVA published some interesting research on timing differences in normalization and tightening (rate hike) policies. A comparison of “past tightening cycles” shows that the length of low rates and the expected length of tightening period is projected to surpass the five other cycles that have occurred in the past 35 years. According to basis point per month calculations, this cycle of “tightening” will occur 31 percent slower than the slowest cycle in 1999. These numbers were published in 2015, and since then, the actual rate of increase has been about 1.3 basis points per month. Even if the Federal Reserve had held to its policy projections in December 2015 (25 basis point increase in Dec 2015 and four 25 basis point increases in 2016), the basis point per month increase would be 6, significantly lower than what investors expected at the time of this paper’s publication.
With such a clear difference in the uptrends of these tightening cycles, it seems clear that the Federal Reserve is trying to implement a different policy framework. BBVA even identified this shift toward tightening suggesting that “’normalization’ is defined as an increase in the Fed funds rate at a point when monetary policy could be assessed as loose.” Even if Janet Yellen and her FOMC cohorts have successfully aligned expectations, coordination, and timing with a policy considered “normalizing,” can we be sure that it will work?
There’s really no way to tell. Markets only have one rate hike under their belt, and that instance led to a sell-off at the beginning of 2016 that threatened to turn into a full-on bear market. Expectations say another 25 basis point rate hike is in the cards for December, so will a similar reaction greet 2017? Once again, it’s a toss-up. One year ago oil prices were significantly more volatile, but the UK had not left the European Union. Growth rates in the United States appear to have stabilized with the most recent GDP figure of 2.9 percent surprising positively, but the Eurozone and Japan had sunk deeper into negative interest rates. The economy is no replica of what it was a year ago, but only a few structural shifts make it distinct.
As far as predictions go, I see a rate hike in December confirming the Federal Reserve’s commitment to “normalization” rather than “rate hike” policy. In that meeting, it will project another three or four 25 basis point rate hikes in 2017, but, like in 2016, that will be an overshoot of its actual path. If markets respond bearishly to the December hike (like this year), the Fed might squeeze in two 25 basis point but one is more likely. If the economy shows improvement and earnings season at the end of 2016 isn’t a total bust, we might see two to three rate hikes. However, the amount of rate hikes in 2017 will always be at least one less than what is projected. This is essential in case the FOMC committee needs to pull out a “bullish surprise” of holding out one meeting so as to avoid any contractionary moves.