The great wall of worry

Well it looks like I picked the wrong day to trash hydrocarbons. Yesterday I quoted FactSet data suggesting that earnings in the S&P 500 energy sector could fall by 66% in the third quarter. They still could, mind you.

But a few hours after my note to you went out, Opec leaders holding an informal emergency summit in Algiers announced the oil cartel’s first production cuts since 2008. The oil price rallied by 6% in New York trading. The aforementioned S&P 500 energy sector was up 4.34%, with most constituents gaining ground on the news.

Is that it, then?

Can you now expect a big rally in oil prices and earnings at energy producers because Opec will reduce demand? Not so fast! The devil, because it’s so easy to hide in there, resides in the details.

First, Opec announced the cut but delayed its implementation until November to work out the details. There’s many a slip between the cut and the… actual cut. This could be Opec’s version of the “talk therapy” practised by central banks. Tell the markets what you want to happen and plan to do (increase interest rates/cut production) it without actually doing it. Markets will price in the words and forget about the action.

Second, the proposed cuts aren’t all that meaningful. Opec’s members are producing about 33.2 million barrels of oil per day, according to its data. It’s an uneasy alliance, at the moment. All of the cartel members are eager to gain market share with low prices. But they have to pay lip service to their cartel membership.

That’s the internal tension of any cartel. There’s always an incentive to cheat. If everyone observes tight production quotas, you control the supply side of the market and keep prices high. But why not cheat a little on the slide? Produce a bit of extra oil off the books and sell at the high prices?

That’s what cartel members tend to do. And the tendency is for everyone to do it. If just one member did it, he could extract maximum advantage from his duplicity. If everyone does it, it’s not really a cartel. And with Opec’s two-largest producers – Saudi Arabia and Iran – being strategic rivals engaged in a series of proxy wars over religion throughout the Middle East, it would be a miracle if they could come to an agreement on oil production levels.

Miracles do happen

But it will take more than a miracle for a 200,000 barrel-per-day (bpd) production cut to lift oil prices. First, all the surplus global oil (the big black glut) has to be sold off and inventories worked down. Then demand has to grow.

The International Energy Agency reckons that a 200,000 bpd production cut would bring the oil market back into equilibrium by mid-summer next year. In other words, if Opec wants to make a big difference, it will need to make a bigger production cut.

But that’s risky. Why? A production cut could spike oil prices. But in a world with low growth, where energy costs are about the only thing keeping some companies from more bottom line pain, a higher oil price might actually reduce oil demand. Producers won’t want to do anything to destroy already fragile demand.

You can see why life is so difficult for a cartel. But as an energy consumer, you can also see why technology tends to drive prices down. That makes competition fiercer and profits harder to generate for companies. But it gives consumers of energy lower prices over time, which I think we can all say is good.

China is the Deutsche Bank of the World

Switching gears from the drama of Deutsche Bank – where the official line is that capital is adequate and liquidity is plentiful – what’s going on in China? It’s your garden variety epic bubble according to billionaire property developer Wang Jianlin. He told CNN that China’s property market is:

[The] biggest bubble in history… I don’t see a good solution to this problem. The government has come up with all sorts of measures — limiting purchase or credit — but none have worked… The problem is the economy hasn’t bottomed out… If we remove leverage too fast, the economy may suffer further. So we’ll have to wait until the economy is back on the track of rebounding — that’s when we gradually reduce leverage and debts.

That’s what everyone has been saying everywhere since 2008. We can reduce debt through growth. But all that’s happened since then is the addition of trillions in debt with very little growth. The only real growth you’ve seen is in financial asset prices (stocks and bonds). Real assets have lagged.

It’s a Chinese version of the same global problem. Monetary policy, via quantitative easing, has “brought forward” a lot of demand. It’s fostered credit growth and real estate speculation. And it’s led investors to take more risk by hunting for yield. It’s thrown savers under the bus and put the use and ownership of cash in the crosshairs of the financial authoritarians.

Everywhere you look you see a risk. The world is a forest of needles in search of a bubble. Or perhaps these are the musings of a paranoid mind. If it’s just a wall of worry, one which stocks climb resolutely and without complaint, it’s one of the most impressive walls in a long time.

Dan Denning's Signature

Category: Geopolitics

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