FRACTIONAL FLOW

Fractional flow, the flow that shapes our future.

Posts Tagged ‘interest rates

Developments in Energy Consumption and Private and Public Debt per 2016

For some time I have explored the relations in developments for total debt [private and public], interest rates, Gross Domestic Product (GDP) energy consumption and thus also the oil price.

My theory has been that there are relations between changes to total debt and energy consumption and thus energy prices. Changes to total credit/debt should thus be reflected in energy consumption. Price formation is also influenced by several other factors and most prominently supply and demand balances.

To me, demand appears to be the one that is poorly understood and demand has been, is and will continue to be what one can pay for.

All transactions involving products and services require some amount of energy thus currency/money becomes a claim on energy.

During the last decades the world was in a gigantic experiment with debt expansion, most recently fueled by low interest policies which allowed to pull demand forward and for some time negate higher prices when demand ran ahead of supplies.

Debt expansions can go on until they cannot, as some economies already have experienced. In the recent decades, growth in total debt was higher than the growth in GDP (ref figure 1) and there is a strong relation between changes to total debt and GDP.

Figure 1: The chart above shows [stacked areas] developments in total private and public debt in Japan (black/grey), Euro area (yellow), US (blue) and China (red).
In the chart is also shown [stacked lines] developments on the Gross Domestic Product (GDP) for the same 4 economies.
NOTE: All data are market value, US$.
The GDP (lines) have been stacked. The bottom line shows Japan, next is (Euro area + Japan) and the top line [China] also shows the total for the 4 presented economies.
Data on private and public debt from Bank for International Settlements (BIS).
Data on GDP from the World Bank [WB]. WB GDP data for 2016 were not publicly available as this was posted.
Note that total GDP for these 4 economies declined from 2014 to 2015.

In this post I also present a closer look at developments in energy consumption and total debts [private and public] for China, Italy, Japan, Spain, United Kingdom and USA.

As of 2016 these 6 countries had about 47% of the total global energy consumption and 42% of the total global petroleum consumption.

As the private sector debt growth slowed/reversed the public sector took over and it appears that public debt growth is not as potent to stimulate growth in energy consumption [and possibly GDP], but sustains or slows the decline in total energy consumption.

Part of the explanation for this may be that much  of the increased public deficit spending is directed towards social programs (more unemployment benefits etc.) which at best may sustain demand.

The 6 countries are presented in the sequence of how I perceive how far they are into the debt deleveraging cycle.

There are other forces at play here as well, as oil companies entered into a bet that high oil prices would be sustained by consumers continuing to have access to credit/debt, which would allow the oil companies in an orderly manner to retire their steep growth in debts required to develop the costlier oil. The debt fuelled growth in investments gradually created a situation where supplies ran ahead of demand, thus collapsing the oil price in 2014.

To me the sequence of events is:

Changes in credit/debt => Changes in energy consumption => Changes in GDP

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Oil, Interest Rates and Debt

At first glance it is hard to see how oil, interest rates and debt are connected. Two of them are human constructs while oil (fossil sunlight), a gift from Mother Nature, took tens of millions of years to process. Oil is an endowment extracted from a confined underground stock and is now the most dense and versatile energy source known to man.

Figure 1: Chart that shows the development of [extraction] cost of oil and interest rates (US 10 Year Treasuries) has developed since 2000 and a likely trajectory for oil extraction costs.

Figure 1: Chart that shows the development of [extraction] cost of oil and interest rates (US 10 Year Treasuries) has developed since 2000 and a likely trajectory for oil extraction costs.

Both lines are SIGNALS, and most likely plan their future based on only one of them.

The 10 Year Treasury (or similar) rate is the reference used for amongst other things to set interest rate for mortgages. Most now, aware of it or not, base their future plans on the expectations to developments of the 10 Year Treasury.

What is now playing out in the oil market may be described as below;

Low interest rates [stimulates debt growth] => Pulls demand forward => Oversupply => Deflation

How will the interest rate develop in the future?

This is important as the present huge global debt overhang weighs heavily in the consumers’ balance sheets and their affordability for costlier oil. It is also important for oil companies’ long term planning to bring costlier oil to the market.

A lasting, low rate makes higher debt loads manageable. Interest rates works both sides of the demand/supply equation.

A higher interest rate will have serious implications for highly leveraged consumers and oil companies.

The dynamics may be described as below:

Higher interest rate => lowers demand => downward pressure on price [deflation] => makes it harder for [highly leveraged] consumers/oil companies to service their debt overhang => lowers investments to develop costlier supplies

At some point in time the present oil supply overhang will come to an end. This will become reflected in a higher price.

The timing of these events creates uncertainties and the agile and financial strong oil companies will sweat out a lasting low oil price.

Few are aware of that the costs of accessing our real capital (like oil) that runs our economies are rapidly increasing.

What is different this time is that the oil price may remain lower for longer than the estimated full cycle break even costs for new developments.

The suggested path for costs is believed in the near term to come down as oil service companies have reduced their prices to shoulder the burden from the recent price collapse. Over time, the capacities of the service companies will become aligned with the demand for their services and products. At some point, as the oil price recovers and investments pick up, the market mechanisms will bring the prices from the service companies up as the service companies also need to make a profit to stay in business.

In figures 4 and 5 are shown how the combination of lower interest rates and a lasting, high oil price encouraged the oil companies to rapidly take on more debt to develop costlier oil on the expectations that consumers had remaining ability to take on more debt/credit to pay for this, thus allowing the oil companies to retire their debts.

The oil companies’ behavior in the recent decade is reminiscent of group think. Few expected the oil price to collapse, though the oil industry itself repeatedly point out the cyclical nature of the oil price.

The aggregate of developments (primarily driven by an amazing growth in the extraction of light tight oil [LTO]) gradually resulted in a supply overhang that made the oil price collapse.

The costs of extracting real capital, like oil, has been rapidly increasing, yet we are making decisions for the future as if it were decreasing, based on the price of capital (money). This is a short term phenomenon that will last until supply and demand become balanced.

The present situation with an apparent oil glut and low prices is a temporary false signal.

This may also be the case with the low interest rates.

The near future will reveal how the competition for available funds to service a still growing huge global debt overhang fare towards the need to fund developments of costlier oil.

Can an increasingly leveraged global economy handle both higher oil prices and interest rates and still remain on its growth trajectory?

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The Oil Price, Total Global Debt And Interest Rates

In several posts I have presented my exploration of any relations between total global debt, interest rates and the oil price.

Sometimes I am left with the impression that when societies’ are looking for a scapegoat for its ills, their reactions bring forth memories from a scene of the movie “Casablanca”, where Captain Renault confronted with solving a crime commands his men; “Round up the usual suspects!”.

For many years one of these “usual suspects” has been and will continue to be: The Oil Price.

However, looking at time series of developments in total global debt and interest rates makes me wonder if not more light should have been directed towards developments in total global debt and interest rates to obtain profound understandings of the fundamental forces that drives the oil price through its ebbs and flows.

In the post “It is the Debt, Stupid” from December 2011 (in Norwegian and refer figure 6) I illustrated how much a 1% increase in the interest rate for public debt in some countries equated to as an increase in the oil price (this was admittedly a simplistic and static comparison, and the exercise was intended to draw attention to the level of debts which made many economies more sensitive to interest hikes than to oil price increases).

Starting in 2014 there has been a steady flow of reports, worth studying, that focused on the growth in total global debt levels, like the 84th BIS Annual Report 2013/2014 and VOX CEPR (CEPR; The Centre for Economic Policy Research) with its “Deleveraging, What Deleveraging?”, The 16th Geneva Report on the World Economy.

In February 2015 McKinsey published “Debt and (not much) deleveraging” which also presents some deep insights into developments of debt by sector for some countries.

Figure 1: Chart above has been lifted from page 1 of the Executive summary of the McKinsey report “Debt and (not much) deleveraging” made public in February 2015.

Figure 1: Chart above has been lifted from page 1 of the Executive summary of the McKinsey report “Debt and (not much) deleveraging” made public in February 2015.

The chart above contains plenty of information about total global debt levels, debt and developments to the growth rate of debt by sector and not least, how total global debt has grown faster than Gross Domestic Product (GDP).

The short version is that post the Global Financial Crisis (GFC) of 2008, which was triggered by too much debt, the global economy was brought back on its trajectory by the use of more debt stimulated by low interest rates.

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CENTRAL BANKS’ BALANCE SHEETS, INTEREST RATES AND THE OIL PRICE

In this post I present a more detailed look at developments in central banks’ balance sheets, interest rates and the oil price since mid 2006 and as of recently.

Paper and digital money are human inventions. Most people truly believe it is money that powers the society and their lives because they have never had reason to think otherwise. Money does not create energy, but it allows for faster extraction from stocks of energy (like fossil fuels) and influences consumers’ affordability of energy.

It is humans’ ability to use external energy that gives humans leverage over other animals. The financial system in general does not recognize oil for what it is, it treats it like another commodity.
We (the aggregate human hive) moved to use more financial debts as a way of pulling resources for consumption (like oil) forward in time when Limits To Growth (LTG) was written. In recent years global credit/debt creation went exponential. The workings of financial debts (created “ex nihilo”) was not included in LTG and the effects of debts are rarely recognized when Gross Domestic Product (GDP) is estimated and its future trajectory projected.

This post takes a closer look at the question:
•   “Could the cumulative effects of the strong growth in oil prices starting back in 2004, which signaled a tighter oil supply/demand balance, upon working their way through the economies, have contributed to forcing the central banks’ to deploy their tools of lower interest rates and growing their balance sheets – measures which have mitigated some of the effects of higher priced oil?”
It is recommended to read this post as an extension to my post “Global Credit growth, Interest Rate and Oil Price – are these related?” where I showed that apparently something fundamentally changed in previous mid decade.

Data from the big western central banks, US Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) have been lifted from the article “Chart Of The Day: The Fed (And Friends) $10 Trillion Visible Hand” which recently was published by Tyler Durden at ZeroHedge.

Figure 1: The chart above is a composite of two charts. The bottom chart shows the developments for the total central banks’ assets on the balance sheets and the interest rate for Federal Reserve [Fed], European Central Bank [ECB], Bank of England [BoE] and Bank of Japan [BoJ]. Developments in total central banks’ assets in US$ Trillion are shown by the green line and plotted versus the outer right hand scale.  Developments in the interest rate (%) are shown by the dark blue line line and plotted versus the inner right hand scale.  On top of the chart and with synchronized time axes is overlaid the development in the oil price (US$/Bbl, Brent spot), red line and plotted versus the left hand scale.

Figure 1: The chart above is a composite of two charts. The bottom chart shows the developments for the total central banks’ assets on the balance sheets and the interest rate for Federal Reserve [Fed], European Central Bank [ECB], Bank of England [BoE] and Bank of Japan [BoJ].
Developments in total central banks’ assets in US$ Trillion are shown by the green line and plotted versus the outer right hand scale.
Developments in the interest rate (%) are shown by the dark blue line line and plotted versus the inner right hand scale.
On top of the chart and with synchronized time axis is overlaid the development in the oil price (US$/Bbl, Brent spot), red line and plotted versus the left hand scale.

Since the start of the global financial crisis (GFC) in 2008 the western central banks (Fed, ECB, BoE and BoJ) have grown their total assets above $10 Trillion and added around $7 Trillion to their balance sheets in the last 7 years.

The overlay with the developments in the oil price on the chart with central banks’ (CBs) balance sheets and interest rate (ref also figure 1), creates the impression that massive CBs liquidity injections and considerable cuts to the interest rate renewed the support for the oil price after it collapsed from its high in the summer of 2008.

The oil price has remained fairly stable since 2011 (around US$110/Bbl) as the western central banks continued to expand their balance sheets at an annual average rate of around US$1 Trillion and kept interest rates low. Then add the expansive credit/debt creation of other big economies, like Brazil and China, during this same period.

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GLOBAL CREDIT GROWTH, INTEREST RATE AND OIL PRICE – ARE THESE RELATED?

For some years my general understanding has been that the price formation for most commercial traded materials/products/items (including oil, which is paramount for all economic activities) is very much related to credit/debt growth, total debt levels and the interest rate (the price of money which also is a measure of credit risk).

In an effort to continue economic growth (to save the system and avoid the mother of all deflations) the worlds leading central banks (US Federal Reserve [FED], the most important one as the US dollar also serves as the world’s reserve currency, Bank of England [BoE] and will the European Central Bank [ECB] soon follow?) in recent years resorted to quantitive easing (QE) and lowered interest rates to almost zero to ease the burden from growing total debt loads. QE was intended to be a temporary measure.

The central banks (CB) actions appear to be a lot about preserving wealth ({inflating} assets) while there is little they can do about nature’s CAPITAL, like energy stocks (most importantly fossil fuels).

The CBs likely pursued these measures as they had few other good alternatives. It appears that the CBs policies may also have influenced the oil markets and helped shape the oil companies’ strategies to deal with a tighter supply/demand balance since 2005 by encouraging them to take on more debt and go after the more “expensive” oil.

The world has also become more complex, interconnected and continued good growth in its Gross Domestic Product (GDP) post the global financial crisis.

CBs do not have the capabilities to create cheap, abundant and lasting energy supplies. For some limited time the world’s CBs and their policies may have alleviated (and for some time continue to) some of the effects of the growth in oil/energy prices, though this was likely not their primary objective when they deployed their policies.

WHAT SUPPORTED GROWTH IN OIL DEMAND AND PRICE FORMATION?

Econ 101 refers to the law of supply and demand as the price arbitrator for raw materials, goods and services. The credit/debt will be assumed and mortgaged against promises to honor it in the future and pay interest.

One understanding of our economies is to view them as thermodynamic flows where money is the facilitator that brings energy/thermodynamic flows to and allocate these within the economies.

During the recent decades, growth in credit/debt (borrowing from the future) grew aggregate demand and to some extent negated the price growth induced from demand growth.

The recent years continued growth in credit/debt was stimulated by lowering the interest rate. By keeping interest rates low, less revenues/funds were needed to service the consequences of the growth in total debts, and thus allowed for continued deficit spending and thus support economic activities at elevated levels.

In March 2014 the Bank for International Settlements (BIS in Basel, Switzerland) published a paper titled Global liquidity: where it stands, and why it matters (pdf file, 200 kB) which presented some interesting data and observations about developments in global bank credit/debt levels.

Figure 01: The 6 panel graphic above shows global bank credit aggregates and the most important borrower regions. The chart at upper left shows that global bank credit more than doubled from 2000 to 2013. In the US [upper middle chart] the growth in bank credit slowed from around 2007 (the subprime/housing crisis) and overall credit growth was continued by increased public borrowing for deficit spending. In the Euro area [upper right chart] the total debt levels led to a slowdown in growth of bank credit post 2008 (or the Global Financial Crisis; GFC) and more recently it appears as deleveraging has started [default is one mechanism of deleveraging]. In the Euro area petroleum consumption is now  down around 13% since 2008. Asia Pacific [lower left chart] which includes China, continued a strong credit growth and thus carried on the global credit growth. Latin America [lower middle chart] which includes Brazil, continued together with Asia Pacific the strong total global credit growth. Global GDP in 2013 was estimated at above $70 trillion.

Figure 01: The 6 panel graphic above shows global bank credit aggregates and the most important borrower regions. The chart at upper left shows that global bank credit more than doubled from 2000 to 2013.
In the US [upper middle chart] the growth in bank credit slowed from around 2007 (the subprime/housing crisis) and overall credit growth was continued by increased public borrowing for deficit spending.
In the Euro area [upper right chart] the total debt levels led to a slowdown in growth of bank credit post 2008 (or the Global Financial Crisis; GFC) and more recently it appears as deleveraging has started [default is one mechanism of deleveraging]. In the Euro area petroleum consumption is now down around 13% since 2008.
Asia Pacific [lower left chart] which includes China, continued a strong credit growth and thus carried on the global credit growth.
Latin America [lower middle chart] which includes Brazil, continued together with Asia Pacific the strong total global credit growth.
Global GDP in 2013 was estimated at above $70 trillion.

Private and public debt growth through the recent decades added support for the increased oil consumption and negated the effects of higher prices caused by a tight supply/demand balance. In recent years the consumers (private sector) in many Western countries are at what appears as debt saturation, and several sovereigns are trying to carry on the overall debt growth through increased  public borrowing and deficit spending, albeit at lower levels.

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