Saturday, 3 January 2015

Oil Prices. Good For The Economy, Terrible For Financial Markets - Part 4

One way of thinking about the oil price is to consider it in terms of a simple balance. On one side weights are added representing demand, and on the other weights representing supply. At the start of the Spring phase of the long wave cycle, although there has been a dearth of investment in the development of new oil supplies, there is enough to meet the subdued level of demand, as economic activity is itself low at this point. The demand for oil is relatively low, especially as new technologies have improved the efficiency of oil and other energy use. A look at the balance shows that the supply side outweighs the demand side, so that the price of oil is low. But, the strength of growth in demand, as economic activity rises sharply during this Spring phase, causes the rise in demand to constantly outstrip any potential for supply to be increased, because any such rise in supply, on a large scale, requires several years of exploration and development.

The price thereby rises. The supply cannot respond quickly to the increased prices, and profits created. There are surplus profits created, which gives rise to additional rent, which is appropriated by landowners (for example the Gulf rulers, the state in northern Europe, and elsewhere, which is then recirculated as petro-dollars in money markets, pushing down global interest rates, and fuelling financial bubbles in stock, bond and property markets). On the other hand, even as the price rises, this does not hold back demand for oil, as global growth continues to rise sharply, and as new technologies mean that the unit energy costs rise proportionately less than energy prices.

Even when additional supply does begin to come on stream, it can take some time, before this higher level of supply exceeds the demand. In other words, its like continuing to add weight on one side of the balance, and it only reducing the extent of the imbalance. But, just as it took some time for the supply to respond to the higher prices and profits, at the start of this process, so now it exceeds it by a significant amount, and the increase in supply continues for some time, even after supply has already risen enough to exceed demand. Then the price drops sharply. That is the situation we have now.

Going back to the comparison with the simple balance, too much weight has now been put on the supply side of the balance. As the price drops, this causes some of the supply to be taken out, but thinking about the comparison with the balance its no longer a matter of continuing to add weight to obtain a balance, but of taking some away, because too many had been added. Then we might find a few too many had been removed, and some needed to be added again. In other words, instead of a fairly steady upward movement in oil prices as seen through the Spring phase, as ever more supply has to be added to try to keep up with demand, now with supply and demand more in balance, around the price of production, the market price may more or less plateau, but to keep it at this equilibrium level, prices will fluctuate more up and down, as supply has to be continually adjusted to the level of demand, and as marginal producers, are now continually in danger of being thrown out of production. For the same reason, the previous surplus profits are slashed, and the potential for rents are diminished.

There is a significant difference between surplus value that finds its way into the pockets of productive-capitalists, and merchants, as opposed to that which finds its way into the pockets of landlords, money-lending capitalists, or the state. None of the latter have any objective dynamic that drives them to utilise their share of the loot productively to expand capital. They transform surplus value, in its money form, as potential money-capital, into money simply as revenue. That includes, where they use it for purposes of speculation in the purchase of fictitious capital, buying shares, bonds, or property, which pushes up the prices of these financial assets.

This process contributes to the inflation of global financial markets, without contributing anything to the actual expansion of value, or surplus value. But, if the price of shares and bonds is simply driven higher on the back of this money chasing a limited supply of those assets, whilst the process contributes nothing to the actual expansion of capital, and thereby of surplus value, the increase in surplus value must always tend to lag behind the rise in those asset prices. The relation between the two, is the price/earnings ratio, which is also manifest in the form of yields.

It is no wonder, therefore, that for the last 30 years, yields have been declining, as the nominal value of bonds and shares has risen inexorably, whilst the growth of surplus value, whilst massive, has not been so large. It is also a period when p/e ratios have risen continuously, and formed the basis of repeated stock market crashes. According to Robert Schiller, his Cyclically Adjusted Price Earnings ratio for the S&P 500, now stands at 28, which is higher than it was in 2008. Yet, if other factors are taken into consideration, this probably still understates the degree of overpricing of the market. The price earnings ratio is affected by several factors – most obviously, the share price, and the earnings per share, which are the two variables being related to each other. But, the earnings per share is itself a function of the total amount of profits, and the number of shares.

If the total profits are £1 million and there are 1 million shares, the earnings per share are £1, but if there are 2 million shares, the earnings per share are only £0.50. If the price of these shares is £10, then in the first case the p/e is 10, whereas, in the second case, the same amount of profit, results in a p/e of 20. Whether, the p/e/ ratio for the market is high or low, therefore, also depends upon whether more shares are being issued, or whether shares are being bought back by companies. When more shares are being issued, the p/e ratio will then tend to rise, causing shares to be sold off, so that their prices fall, and vice versa.

In more recent times, one effect of the huge money hoards that many large companies have built up, and also because companies have been able to borrow in the money markets at very low interest rates, for the same reason, is that fewer new shares are issued, whilst there have been record numbers of share buybacks undertaken by companies. In other words, the reduced number of shares in circulation, artificially increases the earnings per share figure, even when no actual rise in earnings has occurred, and as a consequence, it makes the price/earning ratio for the market appear much lower than it actually is.

The fall in the oil price, therefore, has a number of consequences for financial markets. Firstly, as seen earlier, because a number of smaller energy producers, that rely on loaned money-capital, obtained via the junk bond bond market, are likely to go bust, and default, this has the potential to cause a financial panic, as junk bond markets crash, with as yet unknown implications for wider credit markets. There are already signs that credit conditions are tightening in these markets.

Secondly, the fall in the oil price by significantly reducing surplus profits, also thereby reduces global rents. These rents are a significant source of money hoards, used not for productive investment, but as loanable money-capital, pushing down global interest rates, and pushing up global financial asset prices. A thought not just for the operation of the Gulf Monarchies, in this respect, but for things such as Norway's Sovereign Wealth Fund, give an indication of the scale. Its oil fund currently stands at a value of $857 billion, and accounts for 1% of global equities. It owns 1.78% of all European stocks, making it the largest single stock holder in Europe.

A reduction in these rents, will put downward pressure on all rents, and consequently upon this supply of potential money-capital. It will act to push up global interest rates. As set out in a previous instalment, this will be magnified by the fact that the states that relied on this revenue to finance their budgets will now have to finance them via borrowing themselves on global money markets. This comes at a time, when capital globally needs to invest considerable sums in social capital for infrastructure, and in fixed capital and development in order to be able to operate efficiently, and maximise profits.

As Marx points out, this demand for additional money-capital, i.e. real, productive-capital in its money form, cannot be provided by central banks simply printing money tokens, or increasing credit. This inexorable rise in the demand for this money-capital, relative to its demand, means that global interest rates are set to rise far more sharply than is currently anticipated, and such rises in rates, always spell the death knell of financial bubbles.

No comments: