US Recession Risk Assessment - Interest Rates

Talk has recently turned to recession in the US.  One indicator used is the differential between 10 year and 2 year government bonds, under the assumption that two year bonds are more sensitive to the business cycle and act as a leading indicator.

So, how do things look?

On the graph below, we can see the 2006 to 2012 period.  In mid-2007, two year rates (green) started to plummet.  By contrast, ten year rates (blue) declined, but more modestly.  By this metric, the 2-10 interest rate differential (gray) gave about six months' notice of a pending recession.

US Ten Year (blue), Two Year (Green) Bond interest rates, and 10-2 Year Differential (gray) Source: US Treasury

US Ten Year (blue), Two Year (Green) Bond interest rates, and 10-2 Year Differential (gray)

Source: US Treasury

How do we look now? 

After 2012, the differential stabilized, but jumped back up to 3% in late 2013 (but no recession), and has since declined in almost secular trend.  At 1.2%, the differential is at it lowest level since early 2008.  In other words, as of the 15th, the differential spoke to the continued consolidation of the economy.  Now, it is true that the short rate has declined by 30 basis points in the last few weeks, but so has the long rate.  Thus, the decline for the moment looks more like overall credit conditions (fear and loathing at the PBoC, in my opinion), rather than specific US cyclical economic factors.

Another Decline: US New Car MPG (January 2016)

US automobile fuel efficiency declined for the fifth time since May, according to a report issued by the University of Michigan’s Transportation Research Institute (UMTRI).

New car fuel efficiency peaked in August 2014 at 25.8 miles per gallon, and has since fallen to 24.9 mpg for December 2015.

During the period of high oil prices, US vehicle mileage was improving as much as 6% per year, and averaging 3-4%.  With the collapse of oil prices last summer, the US consumer now prefers larger cars with more powerful engines, resulting in explicit fuel economy declines.  Mileage is declining at the pace of 0.8% per year. 

We anticipate fuel economy to continue to decline at the pace of about 0.1 mpg per quarter.  Had oil prices remained elevated, new cars would likely have seen a 4% sales-weighted efficiency gain over the last eighteen months.

Weak Brent. Is it supply, or demand?

In this article written for CNBC, I review the Bank of England's oil price model, which suggests that weakness in global demand was responsible for 60% of the decline in oil prices since it's recent peak in 2014.

China has to be the principal source of demand weakness, and that in turn seems to be driven by an over-valued yuan. 

Capital Economics, a consultancy, reports this morning (Dec. 7) that capital outflows from China have increased again, apparently on expectations of pending remnibi devaluation.  If the BoE model and our interpretation is correct, a RMB devaluation should be bullish for oil, perhaps quite bullish.

You can read the full story here:

Why oil could rally big in 2016


Fact Checking Mark Carney's Climate Claims

Mark Carney, Governor of the Bank of England, touched off a firestorm of criticism by claiming that catastrophic climate events are in store.  In a speech given to the insurers group, Lloyds, Mr. Carney stated that “the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors”.   The Bank of England apparently feels it can state unequivocally the course of climate events well into the future.

So, let's look at Governor Carney's claims and how they stand up.

Read More

A Eulogy for Shell Alaska

This article originally appeared in the UAE's National newspaper under the title

Shell’s Alaskan oil plan makes long-term sense amid questions over shale’s longevity


Shell announced this week that it was abandoning efforts to develop oil from the Alaska’s outer continental shelf (OCS).

The company had drilled a well in the Burger prospect in the Chukchi Sea this past summer, but the results were disappointing. Although the company found hydrocarbons, the flows were insufficient to warrant further exploration. With that, Shell decided to suspend activities in Alaskan waters indefinitely.

Shell had such high hopes. If all went well, it would have produced an average of 650,000 barrels of oil for 35 years from the OCS. From 2025 until 2060, the OCS would power Alaska’s economy and contribute up to 10 per cent of domestic US oil production.

The project, which we estimated would cost more than US$300 billion in total, would have represented the largest infrastructure project in the United States in the next 15 years.

There was no more visionary initiative anywhere in the world.

For Shell, the Alaskan OCS was the third leg in the company’s answer to peak oil. Shell was among the first to recognise in 2005 that increasing oil production would be a heroic undertaking. Finding new oil would be “no cheaper, no easier”, it said.

To meet the challenge, Shell proposed a three-legged strategy. First, a massive gas-to-liquids plant would be constructed in Qatar. And it was. The Pearl GTL plant, as it is called today, came on line in 2011. It produces 8 per cent of Shell’s total output, equalling 260,000 barrels of diesel and lubricants daily.

The second leg of Shell’s strategy rested on a series of liquefied natural gas plants. These plans were essentially scrapped earlier this year when Shell cancelled four LNG projects.

This left the third leg, Alaska, which was perhaps the jewel in the crown. The scale of ambition, the volumes, the duration and the vision were breathtaking. The commitment was enduring. Even when the going got tough, Shell hung in there and continued to fight for Alaska, despite headwinds from regulators, Greenpeace and a series of technical setbacks.

With weak initial well results, however, Shell capitulated and has suspended operations in Alaska “for the foreseeable future”, which should be read as “permanently”.

The vision of oil scarcity that fuelled Shell’s ambitions after 2005 has dissolved, the victim of the shale revolution. As little as two years ago, the promise of shale was uncertain and underestimated (not least by me).

Whereas Shell was prepared to go to the ends of the earth for new oil, company management could have driven a couple of hours from corporate headquarters to a fully plumbed basin – the Permian – and produced more oil with nothing more than fracking and horizontal drilling.

Alaska is redundant under such circumstances. Consequently, until the shale revolution has run its course and oil prices have returned closer to $100 per barrel, expect Shell to keep its distance from Alaska. By the time the dust has settled, the wait could be a decade or more.

And yet I still believe in Shell’s earlier vision. Shale may prove an endless cornucopia of new oil, but maybe not. The oil and gas division of North Dakota’s Department of Mineral Resources has estimated that Bakken shale oil production would only be 35,000 barrels per day higher at the end of 2017 than it is today, even at Brent oil prices above $95 per barrel. Restarting US shale may take much higher prices and much more time than anticipated.

The flood might not last. No one expects shale growth to last past 2025, and many see a peak before 2020. Shell, by contrast, would not have begun flowing oil from Alaska until after 2025.

If we look in decadal terms rather than quarterly, Shell’s visionaries may ultimately be vindicated. Shale, to the best of our knowledge, will not cover us for more than a few more years. In all likelihood, we will need the oil for which Shell is searching in Alaska.

Nor has Shell entirely closed the door. Marvin Odum, Shell’s director of upstream Americas business, has said that Shell “continues to see important exploration potential in [offshore Alaska], and the area is likely to ultimately be of strategic importance to Alaska and the US.”

With oil prices at current levels, however, even three months has become a long time for a company such as Shell. Why was its decision to abandon Alaska announced two days before the end of the quarter? One might speculate that third-quarter financial results would be so disastrous that Shell would want to be able to demonstrate tangible, direct and immediate commitment to reducing expenses and capital expenditures. There is no easier place to cut than Alaska.

Even if everything went well, Shell would not see a dime from Alaska for at least a decade. Terminating Alaska improves the bottom line immediately.

But at what cost? We have allowed the surplus of shale oil to lull us into a false sense of security, that oil has become “cheaper and easier”. And in the short run, it has. But the long run is far from decided.

For now, oil in Alaska is dead. It is dead in Norway and Russia as well. Norway’s Statoil is struggling with costs on its Arctic Johan Castberg project, and Rosneft has conceded that it cannot proceed in Russia’s Kara Sea without its partner ExxonMobil.

Arctic oil, until the shale revolution ends, is in a deep freeze. But this does not mean that we will not need that oil, nor that current oil prices are sustainable.

Rather, the economics of the oil business have become so dire that even the most committed and visionary of companies are forced to abandon their most cherished plans.

China Excess Inventories

In August, China's commercial crude oil and refined products inventories, adjusted seasonally and for demand growth, turned sharply negative. 

Crude oil excess inventories, which stood as high as 20 mb in March, fell to -19 mb in August.  Gasoline inventories, which were 7 mb below normal in January, were 19 mb below normal in August.  Diesel, relegated to the status of an undesired by-product of the refining process, saw excess inventories peak at 20 mb in July, and fall to 12 mb in August (partly due to hefty exports).  Overall crude and product inventories came in 27 mb below seasonal, demand-adjusted averages.

Anyone looking for excess commercial oil inventories will not find them in China.

China Excess Inventories - Aug 2015.png

China Tracker - Sept. 2015

China's economy is both hard to understand and critical in determining the oil price.

As a result, I thought to initiate a China Tracker, which looks at some indicators of China economic performance.

Bottom line: China suffered some sort of adverse economic event starting in Q3 2014.  The evidence suggests this was mostly the side-effects of an over-valued yuan.  However, China's private debt-to-GDP ratio is at a level often associated with financial crises in other countries.

The basic prescription for China would be a simple devaluation to bring the yuan back into line with similar currencies. 

China Tracker Sept. 2015

A Fiscal Policy Rule for Oil Exporters

This article originally appeared in the UAE's National, under the title

The price of oil is tied to government budgets

The graph in the version below is better.


My uncle, a noted macroeconomist, recently asked me if I could suggest a fiscal policy rule for oil exporters to help them planning government spending in the face of volatile oil prices.    

Of course I could.  Here it is.

Oil is the life-blood of the global economy, and therefore GDP and oil prices tend to be related.   Therefore, it seems appropriate to use a model is based on global spend on crude oil as a percent of world GDP.  If oil prices are too low, supply will falter, the global economy will sooner or later become starved of oil, and prices will rise.  On the other hand, if prices are too high, then the consumer economies will stagnate, new oil production will come on line, and oil prices will decline. 

Source: BP Statistical REview, IMF, Prienga estimates and forecasts

Source: BP Statistical REview, IMF, Prienga estimates and forecasts

On the high side, oil spend equaling 5% of GDP implies ‘stagflation’, ‘secular stagnation’ or outright recession in the advanced oil importing countries.  Oil prices are not sustainable at that level without ascribing to some variation of peak oil.  Today, 5% of GDP equals about $110 / barrel.   That’s a very high price historically, and not suitable for fiscal planning purposes given current realities.

On the other hand, oil spend is rarely less than 1.5% of global GDP, which would seem to constitute a planning floor.   This leaves us with a rather unwieldy range of 1.5-5.0% of GDP for fiscal planning purposes.

But we can narrow this range.  Importantly, oil spend rarely falls into the range of 2.5-4.0%.  Only three years in the last 35 saw oil prices in this range.  Why?  We would argue that oil is either supply-constrained or demand-constrained.  If it is supply-constrained, then oil will become a shortage commodity, as we saw from 1979 to 1986 and from 2004 to 2014, and spend will range 4-5% of global GDP.  On the other hand, if the oil supply can respond flexibly to demand, then oil prices will be demand-constrained, implying spend of 1.5-2.5% of GDP, with an average of about 2% of GDP.    There is no middle ground, historically.  Either oil is a shortage commodity, or it is not.

Thus, much depends on one’s view of the future oil supply.  If you believe that oil will remain plentiful, then fiscal policy should assume an oil price equal to 2.0% of global GDP in the long run, perhaps a bit higher in the medium term. 

I would add that our expectations depend heavily on the experience after 1986, when oil prices last collapsed in such great magnitude.    At the time, a period of extended low prices was readily foreseeable.  High oil prices had been maintained by progressive OPEC production cuts, which in turn created global spare capacity equaling 13 mbpd, or 25% of global consumption.   This enormous surplus required almost 20 years to clear—two decades known as The Great Moderation.  However, there is no such surplus today.  Indeed, surplus capacity is probably not more than 1-2% (1-2 mbpd) of oil consumption, a level which would ordinarily be considered critically low.

On the other hand, the world has roughly 300 million barrels of excess oil and product inventories.  Even if drawn at the pace of 1 mbpd, they would last almost a year.  Second, shale oil appears to be a scalable resource, which can be brought back on line quickly if necessary.  If this is true, then a buffer exists—by far not as great as in 1986—but one which might last anywhere from a year through the rest of the decade. 

If one allows the 1986 precedent, then fiscal policy should be set assuming oil prices will equate to 2.3% of GDP, as they did from 1986 to 1990.  In dollar terms, that would imply a spot Brent oil price of $50 / barrel today, rising to $60 / barrel in 2020.  As Brent currently hovers around $48 / barrel, the sustainable price would appear to be above the current price.

On the supply side, maintaining such low prices looks quite a challenge.  At current prices, many shale operators are facing bankruptcy, the oil majors are liquidating themselves, and OPEC governments are suffering for a lack of revenues.  The situation looks untenable for producers.

To maintain low prices, China would have to suffer a recession--GDP growth of 2% or less--thereby pushing its neighbors into outright recession.  The script would follow the Asian financial crisis of 1998.  At the time, oil spend fell to 1.1% of global GDP, equal to $25 / barrel into today’s terms.  Of course, assessing China’s outlook is a complicated matter.  For now, let it suffice to say that maintaining current oil prices depends intrinsically on weakness in China, not on the ability of oil producers to flood the market at $50 / barrel Brent.

Those oil exporters who believe that oil is not a shortage commodity should plan for sustainable prices over the next five years at 2.3% of GDP, approximately $50-60 / barrel on a Brent basis.  For those who believe that China still has a future, and that oil is still hard to find, well, your analysis will be more complicated.

Shales, the US Trade Deficit, and Dollar Appreciation

Why is the US dollar so strong?  This is a complicated question, but we have reason to believe that US shale production growth may be a principal driver of dollar appreciation.

In the 1990s, US oil imports (defined here as net crude oil imports minus net refined product exports) averaged less than 1% of GDP.  Indeed, when oil prices collapsed in 1998, net imports bottomed at only 0.5% of GDP.  After that, however, imports as a share of GDP continued to rise.  From 2000 to 2007, oil imports soared to 2.7% of GDP, culminating in the Great Recession of 2008.  With the recession, US oil consumption and oil prices collapsed, and oil imports fell back to a more manageable--but still historically high--percent of GDP.

After the trough of the recession, oil prices began a quick recovery, spiking with the Arab Spring of 2011.  This sent Europe into a three year recession.  By contrast, the US escaped with mere 'secular stagnation.'  Why? 

Shale oil production saved the day.  Shale oil began to materially affect the US economy in 2011, as US oil increasingly displaced imports.  From 2011 through 2014, oil imports were falling by more than 1 mbpd / year, reducing the import burden by 0.4% of GDP per year.   Until 2014, this was achieved essentially through increases in US oil production, as oil prices remained stubbornly high. 

By the second half of 2014, however, not only was US production soaring, oil prices were plummeting.  As a result, in 2015 alone, the import burden will have fallen by 0.6% (percentage points) of GDP.   Thus, US oil imports fell from a peak of 2.7% of GDP in 2005, to a mere 0.5% in 2015, the lowest since the Asian Financial Crisis of 1998. 

Source: EIA, IMF, Prienga estimates

Source: EIA, IMF, Prienga estimates

But how much of this is due to US shale oil production?  As it turns out, we can estimate this number.

Had the US not increased its output with shale, the country would have had to import the increment, a difference of around 4 mbpd in 2015.  Further, without shales, oil prices would have likely remained in the range which prevailed during 2011 - July 2014, that is, around $110 / barrel on a Brent basis.

In such an event, US imports would still have declined, in part due to decreased consumption and in part due to increased production in the US Gulf of Mexico.  But imports would have remained quite high by historical standards, above 1.7% of GDP and a percentage point more than in the 1990s.

What would have happened to the economy in such an event?  Europe and Japan provide some insight.  Europe was in recession from 2011 to 2013 and Japan has struggled on and off to get its economy out of the doldrums.  Without shale production, US 'secular stagnation' would probably have looked more like a prolonged recession, as the country struggled to reduce its oil import bills by increasing efficiency.  Due to surging shale oil production, however, the US escaped the need to drastically curtail oil consumption, and the country rebalanced its current account with simple import substitution.  Oil saved the day.

We can also look at this in dollar terms.  In 2008, the US spent nearly $400 bn (in 2008 dollars) importing oil.  In 2015, this bill will have fallen to a mere $90 billion, a drop of more than three-quarters.  This year alone, shale production will have saved the US $250 bn in oil imports, reducing the trade deficit by an impressive $20 bn per month.  Is it a surprise that the dollar should be strong?

Source: EIA, IMF, Prienga estimates

Source: EIA, IMF, Prienga estimates

Nevertheless, the story ends on a cautionary note.  US oil production is falling and is likely to be lower in 2016 than in 2015.  Moreover, US oil consumption is rising quickly, up about 3% so far this year.  And finally, oil prices are likely to rise, possibly quite substantially.  Thus, the US in 2015 will probably see its lowest oil import bill for the next several years. 

How things turn out in the long run depends intrinsically on the path of US shale oil production.  Markets will correct and oil prices will recover.  If US shale fulfills its promise, then shale oil growth will return, and US oil imports may once again begin to fall.  Conceivably, the US could become an oil exporter.  In such a case, the oil trade deficit could once again begin to fall.  Indeed, the deficit could become a surplus.

But more likely, if US shales perform reasonably well, the US oil trade deficit will stabilize at a fairly low level, below 1% of GDP.   The US will remain a modest oil importer, and oil prices will stabilize at a higher level, but well below $100 / barrel.  The US oil import bill will look manageable, much as it did during the go-go days of the 1990s.   It's not everything, but still a pretty good outcome.