In "Crude's Carnage To Continue And Break The 2009 Low," I briefly touched on how the shale boom in the U.S. is a bubble formed from the Federal Reserve's quasi-monetary policy.
Comments erupted that I should not blame the Fed but blame the shale companies for over-indulging in the abundant "free" money.
That is the equivalent of saying do not blame the drug pushers, blame the drug addict for taking the drugs and overdosing. Well, if no one was there to push the drugs then less people would be overdosing. Despite the copious data and research proving the Fed creates bubbles, many people believe the Fed is in it for the "good" fight. We are all witnessing unprecedented asset price growth, whether it is stocks, bonds, housing prices and oil prices - until recently. Against a global slowdown, which was suppose to be cured by the trillions poured into the markets by major central banks, oil producers continue to produce black gold.
Production has hit multi-decade highs. When the Fed introduced quantitative easing for the third time in 2012 - because the first and second doses worked so well - U.S. oil production increased over 70 percent.
Tom Fowler, Wall Street Journal, wrote in January of 2013:
"U.S. oil production grew more in 2012 than in any year in the history of the domestic industry, which began in 1859..."
The Federal Reserve's decision to hold interest rates at historical lows created the environment that supports borrowers. The environment almost forces borrowing to fuel spending. Those in tune with how monetary policy works will be able to connect the dots. This past April, Mark Lewis from Kepler Cheuvreux said, during a CNBC interview,
"I think it's questionable whether we would ever have had the increase in oil production we've had out of the shale plays over the last three or four years if we hadn't been in this environment."
The easy money is a red flag, and the potential for a industry wide credit crunch is huge.
According to Bloomberg, the drilling industry is devoting more revenue to interest payments then ever before. Continental Resources Inc (NYSE:CLR). put the Bakken Shale oilfields on the map. They also spend almost as much paying interest as Exxon Mobil (NYSE:XOM), yet Continental is 20 times smaller. Gold producers bled money as gold jumped several-hundred percent after the Federal Reserve began it's quantitative easing program. Because prices kept rising, producers kept spending.
It is now crude's turn. It is easy to be inefficient when prices are always rising, but when they turn is when the House of Pain begins to accept reservations. Perhaps the shale industry is a derivative of the U.S. government. Bloomberg reported, for those included within their index, for every $1 earned, shale companies spent $4.15. The Economist reported that "so far this year oil-production firms have raised $15 billion of equity and $20 billion of bonds, helped by frothy markets, a near-zero Fed Funds rate."
It continued:
"Listed E&P firms owe $235 billion and during the first quarter debt rose, reflecting continued heavy spending. Assume a firm is in trouble if its net debt is more than eight times its annual cashflow from operations (based on the annualised first-quarter figures and excluding the benefit from derivatives)."
"On the basis of this snapshot, 29 of the 62 firms are distressed, owing a total of $84 billion. Listed shale firms with distressed balance-sheets account for 1.1m barrels a day of oil production, or 1.2% of global oil production."
This year, Standard & Poor's has lowered the outlook, or downgraded, the credit of almost half of the 105 U.S. E&P companies that it covered.
When the Fed keeps rates lower for longer, companies that should not have access to easy money do.
The Federal Reserve Chair, Janet Yellen, has even expressed concerns with asset prices, as well as much needed improvement in economic data.
However, the Fed is caught in between deflation and a bubble. The Fed wants to raise rates because they have effectively used up every tool at their disposal and have nothing left as the business cycle is beginning to end and the next recession is looming. However, they cannot raise rates. At least they cannot meaningfully.
Everything is somehow tied into the Fed's policies: stocks, bonds, interest rates, housing, etc. And to say the Fed does not create bubbles is myopic. The motto this entire "recovery" has been "don't fight the Fed." An article from the Wall Street Journal featured something both interesting and scary:
At Morgan Stanley (NYSE:MS) Investment Management, we have analyzed data going back two centuries and found that until the past decade no major central bank had ever before set short-term interest rates at zero, even in periods of deflation.
.. [in regards to low inflation] this ignores the fact that when money is nominally free, strange things happen, and today record-low rates are fueling an unprecedented bout of inflation across asset prices.
Commodities are simply the first to fall, as they did in 2008. Commodity prices do not drive economic growth. Economic growth drives commodities prices. The collapse in commodity prices and lack of inflation are tell tale signals that the global economy is at a standstill.
Ruchir Sharmar's article sum's it all up:
"Every major economic shock in recent decades has been preceded by an asset bubble: housing and stocks both before Japan’s meltdown in 1990 and before the Asian financial crisis in 1998; stocks before the U.S. dot-com bust in 2000; housing again before the crisis in 2008. Strikingly, even as asset prices were climbing before the busts of 2000 and 2008, the Fed kept monetary policy loose because consumer prices were rising only moderately. That is the same excuse we hear now, amid a price boom in stocks, houses and bonds."
Those that rush to defend the Fed believe the Fed is doing what it has to without realizing it's merely reacting to their screw-ups in the first place.
The Fed, academic economists in general, are devoid of reality. Dr. Paul Wilmott, who warned of a derivative led-meltdown prior to 2008, said that economists are unable to relate with how the world works; and is why the Fed is always reactive to a crisis it starts.
Among bubbles in the above mentioned above, a bubble in corporate debt has formed. As customers began to deliver following the Great Recession, businesses quickly took the handout.
Political economist John Stuart Mill said it best:
Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.
It will only get worse.