Monday, August 31, 2015

Will We See The Return of Quantitative Easing?

A very interesting posting by Ray Dalio, Chairman and Chief Investment Officer at Bridgewater Associates, L.P. a hedge fund that manages $169 billion in global investments looks at what lies ahead for the Federal Reserve, now that global stock markets have shown a great deal of volatility.  With the Fed telegraphing that it would consider lifting-off interest rates sometime during the late third and early fourth quarter, the recent volatility in both commodities and stocks must be giving the world's most influential central bankers reason to ponder their decisions to both taper and lift-off.

In the minutes from the July 28 - 29, 2015 FOMC meeting, there are repeated references to inflationary pressures falling below the 2 percent threshold as we can see in these quotes:

"Inflation had continued to run below the Committee’s longer-run objective, but members expected it to rise gradually to- ward 2 percent over the medium term as the labor mar- ket improved further and the transitory effects of earlier declines in energy and import prices dissipated."

"However, core inflation on a year-over-year basis also was still below 2 percent. Moreover, some members continued to see downside risks to inflation from the possibility of further dollar appreciation and declines in commodity prices."

Keeping in mind that oil prices have done this over the past 12 months:

...and that commodities as a whole have done this over the past 12 months:

...the Fed's concerns about low inflation/deflation are definitely not unfounded.

Now, let's get back to Mr. Dalio's musings.  He begins by explaining the interaction between short-term interest rates and the returns of other longer-term asset classes.  He notes that central banks want interest rates to be lower than the returns that investors can gain by borrowing money to purchase longer-term investments.  He notes that if short-term interest rates were always lower than the returns of other asset classes, everyone would run out and borrow cash to own higher returning assets.  Central banks can step in to control this process by raising interest rates when the growth in demand for assets outstrips the capacity to satisfy the demand, thereby controlling inflation and economic growth levels.  On the other hand, declines in interest rates cause asset prices to rise, largely because the lower interest rates reduce the discount rate that future cash flows are discounted at, raising the net present value of the assets.

He goes on to state the following:

"…since 1981, every cyclical peak and every cyclical low in interest rates was lower than the one before it until short-term interest rates hit 0%, at which time credit growth couldn't be increased by lowering interest rates so central banks printed money and bought bonds, leading the sellers of those bonds to use the cash they received to buy assets that had higher expected returns, which drove those asset prices up and drove their expected returns down to levels that left the spreads relatively low. 

That's where we find ourselves now—i.e., interest rates around the world are at or near 0%, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high.  As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias.  Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant." (my bold)

He concludes by noting that the "...risks of deflationary contractions are increasing relative to the risks of inflationary expansion..." and that the Fed has boxed itself into a policy corner because it has spent a great deal of time advertising the notion that it will begin to tighten at a time when they should be telegraphing that they continue their current monetary policies.  The title of Mr. Dalio's posting says it all "Why We Believe That the Next Big Fed Move Will Be to Ease (via QE) Rather Than to Tighten".

Only time will tell whether global economic developments will force the Federal Reserve to add to its already bloated $4.487 trillion balance sheet to avoid the spectre of deflation, further pushing its monetary experiment into uncharted territory.

Friday, August 28, 2015

Harperman - The Stephen Harper Song

Thanks to Montreal Simon for the posting idea, here is a video worth watching in this Canadian election season:

And now for the rest of the story.  According to the Ottawa Citizen, Tony Turner who wrote and performed the song that has now received over 50,000 hits on YouTube, has been suspended from his job in habitat planning at Environment Canada (with pay) while Big Brother investigates the making of the video.

So much for the concepts of free speech and free protest in Harperland unless, of course, it's pro-Harper and anti-everybody else in Canadian politics.

The Continuing Problem with Oil Inventories

Updated November 2015

A recent "Today in Energy" posting by the U.S. Energy Information Administration very succinctly explains the reason why oil prices have dropped over the past year and why it is unlikely that the oil market fundamentals will change any time soon.  

Here is a graphic showing global inventory levels for oil and petroleum liquids in millions of barrels per day since January 2008 along with the price of Brent crude:

As you can see on the dark brown bars, oil inventory has been steadily positive since August 2014.  This tells us that global production of both oil and hydrocarbon liquids has outpaced the growth in consumption.  In fact, for the first seven months of 2015, total global liquids inventories have grown by an average of 2.3 million barrels per day, the highest level since 1998 when oil prices collapsed as shown on this chart:

The EIA provides the following data for 2014 and 2015:


Global petroleum liquids consumption growth: 1.2 million BOPD
Global petroleum liquids production growth: 2.3 million BOPD
Average global consumption rate: 92.4 million BOPD

2015 (to the end of July 2015)

Global petroleum liquids consumption growth: 1.2 million BOPD
Global petroleum liquids production growth: 2.9 million BOPD
Average global consumption rate: 93.3 million BOPD

Here is a graphic showing the same data along with a graphical representation of the buildup in global petroleum liquids inventory:

The sources of petroleum liquids supply have changed.  In 2014,  global liquids production growth was from countries outside of OPEC, including the United States, with OPEC production levels actually dropping.  In 2015, increased production levels of petroleum liquids has come from both OPEC nations (up 0.9 million BOPD in 2015) and non-OPEC nations (up 2.0 million BOPD in 2015).

Since global liquids inventories started to build in August 2014, there has been a significant change in   the difference between futures prices and near-term petroleum liquids contracts, increasing from nearly zero in 2014 to between $5 and $10 per barrel.  This reflects the increased cost of growing storage needs and the increased supply of oil.

In the coming months, the EIA expects that crude oil production in the United States will begin to drop as companies respond to lower oil prices and reduce drilling levels.  The latest EIA data shows that U.S. crude oil production has actually risen from 8.7 million BOPD in 2014 to 9.3 million BOPD in 2015 but will drop to 8.8 million BOPD in 2016.  Estimates this that U.S. production averaged 9.4 million BOPD for the first eight months of 2015, actually rising by 100,000 BOPD than the average production rate during the fourth quarter of 2014 despite the fact that the U.S. oil-directed rig count has declined by 60 percent on a year-over-year basis.  This will have an impact on the global level of inventory accumulation which is expected to slow from its current level of 2.0 million BOPD to 1.5 million BOPD in Q4 2015 and to below 1.0 million BOPD in 2016.  That said, the EIA forecasts that Brent crude prices will average only $54 per barrel in 2015 and $59 per barrel in 2016 with the price for West Texas Intermediate averaging about $5 less per barrel than Brent crude.

This data suggests that the oil industry is unlikely to see a quick turnaround, particularly if the global economy continues to show signs of slowing.  While the growth rate in petroleum liquids storage will slow over 2015 - 2016, inventories will continue to accumulate, particularly if Iran adds additional supply.  This suggests that the global oil market could be in for a repetition of what happened in 1998 and that there will be continued downward pressure on prices, at least over the medium-term.

Thursday, August 27, 2015

Stephen Harper and the Elusive Fiscal Balance Mantra

The Harper campaign's mantra is that, in these uncertain times, Canadian voters need to stay the course and vote for the Conservative Party, the only political party that has the ability to steer the Canadian economy through uncertain waters as shown on this video:

Let's take a look at what has happened to Canada's federal financial picture since Stephen Harper first stepped into the Prime Minister's Office on February 6, 2006.  Please keep in mind that the late Finance Minister Jim Flaherty presented his first budget on May 2, 2006, covering the 2006 - 2007 fiscal year.

Here is what the federal budgetary balance looks like since fiscal 2006 - 2007:

Since fiscal 2006 - 2007, the Harper government has spent $122.22 billion more than it brought in as revenues, including a $13.752 billion surplus in fiscal 2006 - 2007 that was largely a relict of the Martin government.  Please note that this total deficit includes a projected $1.9 billion surplus in fiscal 2015 - 2016 which is far from a sure thing given the collapse in oil prices and the slowing of the Canadian economy into near-recession.

Here is what happened to the net federal debt since fiscal 2006 - 2007:

The net federal debt has increased by 23.88 percent over 10 fiscal years.

Like other nations around the world, Canada's central bank has performed a great service to the federal government since the Great Recession as shown on this chart:

The yield on 10 year Canadian government bonds has fallen from around 4 percent in 2006 to its current level of just under two percent.  In fact, if we go back further in time, the yields on Canadian government bonds ranged between 6 and 9 percent during the years between 1992 and 1998 and yet, by fiscal 1997 - 1998, the Chretien government was able to run a small surplus as shown on this graph:

Over the years between fiscal 1997 - 1998 and 2005 - 2006 when interest rates ranged between 4 and 6 percent or between two and three times the current level, the Canadian government of the day was able to reduce the federal debt from $559.9 billion to $481.5 billion.

If interest rates had remained at the elevated levels seen prior to the Great Recession, there is no way that the Harper government would have been able to achieve any semblance of fiscal balance in 2015 - 2016.  It will also be increasingly unlikely that any political party will be able to achieve fiscal balance on a going forward basis if/when interest rates on the outstanding debt rise by even a modest amount, particularly if the economy continues to underperform.

Let's close this posting with a quote from a speech given by newly minted Reform MP Stephen Harper to the National Citizens' Coalition way back in June 1995 about Alberta Premier Ralph Klein's attempts to balance budgets and reduce deficits:

""Although I can't speak of the details because it is not my area of expertise, what Mr. Klein is doing in Alberta is, in principle, what governments need to do.  He is taking a look at a situation that is unsustainable financially and he is taking the steps necessary through expenditure reductions to eliminate that financial uncertainty on a permanent basis within the life of a single Parliament.  That is the only way it ever gets done.  Any politician who says he is going to do it over two Parliaments is never going to do it.  That's the golden rule.  That's something that you can learn from Ralph Klein." (my bold)

Apparently, our current Prime Minster has either forgotten his golden rule or is just ignoring it in the face of the economic reality that he has created for Canadians.  Three strikes and you're out Mr. Harper?