December 22, 2014

By: Kelly Diamond, Publisher

low gas pricesA couple of weeks ago, I wrote about the Russian Hooker Index, which had to do with the increasing cost of living in Russia. Meanwhile, however, the US is enjoying some very low gas prices. I am NOT complaining about the prices one bit! (Just wanted to be super clear on that point, because the last time I was able to fill my tank for $20, was about a decade ago.)

Much like the Russian Hooker Index, however, I am left wondering what economic forces are at play… or more ominous than that, what economic indicators for the future does this hold?

Price fluctuations are attributable to myriad factors. There is the go-to guy: Supply and Demand. Greater supply, especially when combined with reduced demand, will lead to lower prices. Typically, in the US, we see a hike in fuel prices during the summer months when people typically take vacations and do a lot of leisure traveling.

Another player in the price-point game is competition. It’s no secret that monopolies tend to charge exorbitant rates for mediocre services and goods. Just look at ANY government service. Education? The average private school produces a higher graduation rate and has a greater rate of students continuing on to higher education than public schools. The average cost of private schools? Nearly $10,000 per year per student. The average cost of public schools? Nearly $11,700 per year per student. Once you look at it by state, you can see even greater disparities, though not in all cases.

In the case of oil, I think it’s the latter. I discussed the implications for Russia already, but they aren’t alone. Saudi Arabia is engaging in a ruthless price war, and for NOW, the individual consumers are the beneficiaries. This isn’t one of those market checks and balances that have heavy hitters bring down their prices to a more reasonable level. This isn’t one of those competitions where the competition price matches and beats the other by X%. Both of those are sustainable and compels all players to play smarter, while the consumer still comes out as one of the beneficiaries.

The Saudis are not playing a game of “may-the-best-man-win”. They are playing to the death. Specifically, they are playing to the death of their would-be competitors. Russia’s rubble is tied to oil? Pound sand Russia, because the Saudis just undercut your inflated oil. Oh, was the US thinking about tapping its shale oil and becoming the new largest producer in oil? I don’t think so. The Saudis know that the cost to produce shale oil is higher than the cost to just refine straight crude, AND US labor is considerably more expensive than Saudi labor. One by one, Saudi Arabia will wait for all the would-be oil producers to fall off, and reclaim its market share dominance of oil. They did it in the late 80’s and they will do it again.

It’s this balls-to-the-wall at-any-cost mentality that has always eluded the United States. From the Japanese Kamikaze, to China’s deregulation, to Estonia’s e-Residency, to Ireland’s ridiculously low corporate tax rates, the United States is just flat out NOT a competitive player and is easily beat. The competition doesn’t even need to engage in sustainable tactics since the US will tangle itself, trip and fall over its own red tape long before these other countries have to suffer any significant losses to the US.

And while I could go on about America’s economic and strategic short-comings, the potential victims are far more important than the egos of some intellectually bankrupt elites. When was the last time the US saw such a dramatic drop in oil? Rewind to the second half of 2008. That’s right: the housing crisis and subsequent bank bailouts.

I’m not saying that all our booms and busts are somehow tied to oil. But when anything takes a nosedive, it’s important to know what it can potentially take with it. I mentioned that Russia’s ruble is tied to oil, so they know exactly what’s at stake. Our dollar isn’t tied to oil. In fact, it’s not tied to anything except the whims of the Keynesian brain-trust in Congress and the Federal Reserve.

What is tied to oil and other sources of energy, however, is about 15% to 20% of high yield bonds… or what is commonly known as junk bonds. Also there’s this: “The Energy sector accounts for roughly one-third of S&P 500 capex and nearly 25% of combined capex and R&D spending,” writes Goldman Sachs’ Amanda Sneider.

Wall Street has put a LOT of hope and faith in the energy markets, and are relying on it to help the U.S. shift into full recovery mode economically. Rather difficult when no one can make a profit though, right?

Here is the uber simplified timeline of how everything is tied together:

  • The U.S. has producers in North Dakota and Texas excavating and refining shale oil.
  • People are hired, mitigating our unemployment figures.
  • Saudi Arabia, decides to engage in a cut-throat price war.
  • U.S. shale producers cannot compete or make a profit.
  • Doors are shut, corners are cut, and people are laid off.
  • Meanwhile, 15-20% of junk bonds is in energy, and “much of that high-yield debt is now on the books of banks, asset managers and pension funds” per CNBC. “What’s more, banks are even more dependent on a happy junk market as they make a market in the bonds. Any collapse in prices could cause bidders to run and liquidity to dry up.”

What happens next? Larry McDonald, head of U.S. Strategy at Newedge USA’s macro group tell us: “This is the one thing I’ve seen over and over again. When high yield underperforms equity, a major credit event occurs. It’s the canary in the coal mine.”

A credit event? When the housing bubble burst, there was a 30% increase in yield spread between US Treasuries and junk bonds. It resulted in Citigroup losing over 60% of its value and Bank of America being cut in half.

Could it happen again? I don’t see why not. Will it happen? I would say the chances are likely if the US doesn’t change its course quickly.

Obama just happens to be in office when all this is happening, the way Clinton just happened to be in office during the dot-com boom era. This is not directly tied to Obama or his administration as much as it is tied to decades of regulation, bureaucracy, and legislation. With every boom, there is an inevitable bust. That’s just how economics works; and it has little regard for partisan hacks who whimper over social justice and want to condemn the producers of the world. This is, however, a very CLEAR lesson in diversification of investments. When 20% of anything is hanging in the balance, and a sudden or accelerated drop could lead to a crisis, you know that strategy is neither smart nor sustainable.