OIL PERFORMANCE IN A WORLDWIDE DEPRESSION
by Krassimir Petrov, PhDSeptember 28, 2004
In a previous article called “China’s Great Depression”, I postulated that China must necessarily fall into a depression, probably comparable to the American one from the 1930s, which in turn will spread to become a worldwide depression. In response, many readers asked whether in such a depressionary environment the price of oil would go up or down. The straightforward answer is that in an inflationary bust, the price of oil will go up, and in a deflationary bust—down. Of course, the response is evasive, provides no analysis, and answers an ill-defined question. Therefore, the goal of this article is to explain the importance of the question, to define its scope properly, to answer it with sound economic analysis, and to summarize our results.
Over the next decade, oil fundamentals may be characterized as 10+. Oil supply is at or near its “Hubbard’s” peak, and oil is currently pumped at close to 100% capacity. Therefore, growth of oil supply is rapidly slowing down and is expected to decrease in the coming years. On the other hand, China’s and India’s industrialization will continue to drive oil demand at growth rates higher than the growth rates of oil supply, and as a consequence, the price oil has to go much higher in order to ration the relative scarcity of oil supply. In this environment of strong fundamentals for oil, a booming worldwide economy will guarantee much higher oil prices; however, in a worldwide recession, the issue becomes whether the strong oil fundamentals will nonetheless outweigh a slowdown in oil demand. Precisely this issue motivates our present analysis.
The proper definition of the problem requires investigation of the price of oil (1) relative to the U.S. dollar, (2) relative to strong fiat currencies, (3) relative to gold and silver, and (4) relative to a basket of commodities. Below, we investigate each in turn, although I would like to respectfully acknowledge Marc Faber’s seminal contribution in (1) and (2).
The U.S. dollar is fundamentally unsound. It has been used for decades to monetize U.S. government debts and to pay for trade deficits. As a result, the dollar has been overissued in the U.S. and overaccumulated by foreigners. In a worldwide depressionary environment, two decisive factors will drive the dollar’s value substantially lower. First, the injury to the dollar will come from foreigners decumulating their dollar-denominated investments. In a depression, foreign banks will fall on hard times, and they will have little choice but to shore up their reserves by selling foreign-denominated assets and repatriating their capital home. In addition, foreign governments will attempt to stimulate their economies with lowered interest rates, increased domestic investments, and bigger government spending. All of these will be better accomplished by repatriating foreign investments home rather than by pure monetary stimulus, because the repatriation will actually increase the pool of savings within their economies and provide a sound, sustainable basis for the stimulus, while a pure monetary stimulus will provide a credit-based, unsustainable stimulus that is doomed to failure. Second, to add insult to injury, the dollar will come under additional pressure from the Fed’s own inflationary policy, now fighting the more pronounced deflationary forces. No doubt, “Helicopter” Ben will step up the printing press, and as a result, U.S. money supply will continue to increase, at least for a while, and some of the freshly printed dollars will be sold on the foreign exchange markets for better stores of value. Thus, a depressionary environment will exacerbate the dollar’s problems and the dollar is likely to fall a lot more than oil due to its inherent vulnerability. As a result, in a depression, the price of oil is likely to go up in U.S. dollars.
In terms of strong foreign currencies (e.g. Swiss Franc), I believe that in a depression the price of oil will actually fall. These currencies, by definition of being strong, will hold their value relatively well, and their demand will be relatively stronger than demand for oil, because a flight to safety will increase demand for those currencies, while depressionary forces will reduce oil demand. This, of course, assumes no oil wars, terrorism, local political instability, or other unforeseeable disruptions of oil supplies; given such a disruption, all bets are off, and oil will likely rise in all fiat currencies. Under normal conditions, however, the price of oil is likely to fall in terms of strong currencies.
Gold shines bright in a depressionary environment. It is the ultimate safe haven, and in times of crisis it holds its value better than anything else. In a flight to safety, it has always been the top choice for investors. The reason is that in times of crisis, sinking profits crush stocks, looming defaults pressure bonds, credit-crunch chokes real estate, and escalating monetization devalues fiat currencies. In such an environment, there is simply nowhere to run but gold. Even though demand for gold as a commodity collapses, its demand as the only safe money skyrockets; the latter dramatically overcompensates the former, and total demand for gold increases substantially. As a result, gold (and silver) is likely to rise against all currencies, weak or strong. However vital for human civilization, in a depression, oil is no match for gold, and is certain to fall in terms of gold.
Demand for commodities generally drops in a depressed worldwide economy. We base our argument on the fact that oil demand is very inelastic, even when compared to the elasticity of commodities. Thus, in a strong economy, oil prices generally rise relative to commodity prices, and in a weak economy—fall relative to commodity prices. From an Austrian point of view, oil may be regarded as a higher-order capital good relative to other commodities, and therefore in a bust environment, it follows from Austrian theory, that oil prices will fall relative to commodity prices. However, we must acknowledge that the inelasticity argument is not independent of the higher-order Austrian argument, for the higher-order argument naturally implies relative inelasticity. Therefore, one may expect that in a depression, the oil price will most likely fall in terms of a commodity index, such as the CRB, provided that there are no oil disruptions, as already indicated above. To reiterate, with oil supply disruptions, oil is certain to outperform every single commodity, except gold and silver.
We will note a number of important analytical properties. First, nowhere in our analysis did I assume inflation or deflation. Instead, I relied entirely on demand and supply characteristics of a bust, whether inflationary or deflationary. Second, I was able to resolve the problem in terms of currencies because of their explicit choice: the dollar being inherently weak, and strong currencies, being inherently strong. For currencies in the middle of the “strength” spectrum, the answer is considerably harder and somewhat indeterminate. Third, for gold and silver I applied the “safe-haven” argument. Finally, for commodities I applied the relative inelasticity argument.
To conclude, in a depressionary environment, the price of oil will go up in terms of U.S. dollars, and will fall in terms of strong currencies, gold, silver, and a basket of commodities. It follows that the appropriate investment strategy for investors should involve the accumulation of gold, silver, strong foreign currencies, and government bonds denominated in those currencies.
In a previous article called “China’s Great Depression”, I postulated that China must necessarily fall into a depression, probably comparable to the American one from the 1930s, which in turn will spread to become a worldwide depression. In response, many readers asked whether in such a depressionary environment the price of oil would go up or down. The straightforward answer is that in an inflationary bust, the price of oil will go up, and in a deflationary bust—down. Of course, the response is evasive, provides no analysis, and answers an ill-defined question. Therefore, the goal of this article is to explain the importance of the question, to define its scope properly, to answer it with sound economic analysis, and to summarize our results.
Over the next decade, oil fundamentals may be characterized as 10+. Oil supply is at or near its “Hubbard’s” peak, and oil is currently pumped at close to 100% capacity. Therefore, growth of oil supply is rapidly slowing down and is expected to decrease in the coming years. On the other hand, China’s and India’s industrialization will continue to drive oil demand at growth rates higher than the growth rates of oil supply, and as a consequence, the price oil has to go much higher in order to ration the relative scarcity of oil supply. In this environment of strong fundamentals for oil, a booming worldwide economy will guarantee much higher oil prices; however, in a worldwide recession, the issue becomes whether the strong oil fundamentals will nonetheless outweigh a slowdown in oil demand. Precisely this issue motivates our present analysis.
The proper definition of the problem requires investigation of the price of oil (1) relative to the U.S. dollar, (2) relative to strong fiat currencies, (3) relative to gold and silver, and (4) relative to a basket of commodities. Below, we investigate each in turn, although I would like to respectfully acknowledge Marc Faber’s seminal contribution in (1) and (2).
The U.S. dollar is fundamentally unsound. It has been used for decades to monetize U.S. government debts and to pay for trade deficits. As a result, the dollar has been overissued in the U.S. and overaccumulated by foreigners. In a worldwide depressionary environment, two decisive factors will drive the dollar’s value substantially lower. First, the injury to the dollar will come from foreigners decumulating their dollar-denominated investments. In a depression, foreign banks will fall on hard times, and they will have little choice but to shore up their reserves by selling foreign-denominated assets and repatriating their capital home. In addition, foreign governments will attempt to stimulate their economies with lowered interest rates, increased domestic investments, and bigger government spending. All of these will be better accomplished by repatriating foreign investments home rather than by pure monetary stimulus, because the repatriation will actually increase the pool of savings within their economies and provide a sound, sustainable basis for the stimulus, while a pure monetary stimulus will provide a credit-based, unsustainable stimulus that is doomed to failure. Second, to add insult to injury, the dollar will come under additional pressure from the Fed’s own inflationary policy, now fighting the more pronounced deflationary forces. No doubt, “Helicopter” Ben will step up the printing press, and as a result, U.S. money supply will continue to increase, at least for a while, and some of the freshly printed dollars will be sold on the foreign exchange markets for better stores of value. Thus, a depressionary environment will exacerbate the dollar’s problems and the dollar is likely to fall a lot more than oil due to its inherent vulnerability. As a result, in a depression, the price of oil is likely to go up in U.S. dollars.
In terms of strong foreign currencies (e.g. Swiss Franc), I believe that in a depression the price of oil will actually fall. These currencies, by definition of being strong, will hold their value relatively well, and their demand will be relatively stronger than demand for oil, because a flight to safety will increase demand for those currencies, while depressionary forces will reduce oil demand. This, of course, assumes no oil wars, terrorism, local political instability, or other unforeseeable disruptions of oil supplies; given such a disruption, all bets are off, and oil will likely rise in all fiat currencies. Under normal conditions, however, the price of oil is likely to fall in terms of strong currencies.
Gold shines bright in a depressionary environment. It is the ultimate safe haven, and in times of crisis it holds its value better than anything else. In a flight to safety, it has always been the top choice for investors. The reason is that in times of crisis, sinking profits crush stocks, looming defaults pressure bonds, credit-crunch chokes real estate, and escalating monetization devalues fiat currencies. In such an environment, there is simply nowhere to run but gold. Even though demand for gold as a commodity collapses, its demand as the only safe money skyrockets; the latter dramatically overcompensates the former, and total demand for gold increases substantially. As a result, gold (and silver) is likely to rise against all currencies, weak or strong. However vital for human civilization, in a depression, oil is no match for gold, and is certain to fall in terms of gold.
Demand for commodities generally drops in a depressed worldwide economy. We base our argument on the fact that oil demand is very inelastic, even when compared to the elasticity of commodities. Thus, in a strong economy, oil prices generally rise relative to commodity prices, and in a weak economy—fall relative to commodity prices. From an Austrian point of view, oil may be regarded as a higher-order capital good relative to other commodities, and therefore in a bust environment, it follows from Austrian theory, that oil prices will fall relative to commodity prices. However, we must acknowledge that the inelasticity argument is not independent of the higher-order Austrian argument, for the higher-order argument naturally implies relative inelasticity. Therefore, one may expect that in a depression, the oil price will most likely fall in terms of a commodity index, such as the CRB, provided that there are no oil disruptions, as already indicated above. To reiterate, with oil supply disruptions, oil is certain to outperform every single commodity, except gold and silver.
We will note a number of important analytical properties. First, nowhere in our analysis did I assume inflation or deflation. Instead, I relied entirely on demand and supply characteristics of a bust, whether inflationary or deflationary. Second, I was able to resolve the problem in terms of currencies because of their explicit choice: the dollar being inherently weak, and strong currencies, being inherently strong. For currencies in the middle of the “strength” spectrum, the answer is considerably harder and somewhat indeterminate. Third, for gold and silver I applied the “safe-haven” argument. Finally, for commodities I applied the relative inelasticity argument.
To conclude, in a depressionary environment, the price of oil will go up in terms of U.S. dollars, and will fall in terms of strong currencies, gold, silver, and a basket of commodities. It follows that the appropriate investment strategy for investors should involve the accumulation of gold, silver, strong foreign currencies, and government bonds denominated in those currencies.
posted by EMREISERI @ 2:45 PM
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