Oil Boombustology

 

Takeaway

  • Booms create over-building of capital goods and creates an over-supply.
  • Reduced demand and over-supply leads to deflation, default, and depressions.
  • But for oil, the silver lining is in the well itself. Fracked wells have short active lives, and this allows for a smoother adjustment as we aim for equilibrium. 

McCombs Finance Professor Lewis Spellman maintains a finance and economic policy blog called The Spellman Report. Texas Enterprise is pleased to share his latest post each month.  

It’s long been in the DNA of economists and market observers, going back at least to the Austrian School of Economics, that when money growth outpaces the economy’s growth, booms are created and so are busts: Boombustology, as coined by Mansharamani of Yale University.

Certainly quantitative ease as practiced in serial form by today’s central banks fan that concern, but for the most part, the sentiment of central bankers, politicians and the market seems to be “please let there be a boom” — and we’ll dodge the bust.

There are all kinds of booms and busts. Some are of a benign form called behaviourism. They are born of the belief of ever-increasing prices. Tulipomania during Holland’s seventeenth century was a classic. Though it might not carry an entire economy into excess but the rise and fall of tulip bulb prices surely redistributed wealth.

But some booms involve financing to purchase the item that is booming whatever it is. In that case lenders also have to buy into the boom to make it happen. When the item booming requires industrial equipment to produce it, the economic ripples become far-reaching.

The boom mood creates over-building of the capital goods and eventually, the oversupply of the booming item whether we call it tech, housing or commodities. Then, the rising price of the item that precipitated the borrowing and building turns into a free-fall of prices, borrowing and building. There follows an air pocket of demand for the capital goods in question which can then become a generalized demand suppressant and a financial bust.

The lethal combination of reduced demand and over-supply brings into play all the D Words: deflation, default (on the financing), depressions if wide spread and possibly devaluation of the currency, if capital flows to safer ports of call.

Certainly the Great Recession was deep and long not just due to the overindulgence of borrowing and home building but also the permanence of the physical structures left behind that creates a following air-pocket of demand in some places called Ghost EstatesThat is, the durability of the over built real capital determines the duration of following depressed demand and soft prices. And this condition continues and defines the duration of the bust as long as the excess supplies are a silhouette on the horizon as shown to the right.

In contrast, was the boombustology of over-built agricultural capacity during World War I to feed a world at war. At the war’s conclusion, Europe went back into production and this expansion of U.S. agricultural capacity created a supply glut in the commodity markets when Europe went back into production. But given the short life span of the crop and the ability to cut back production, the US deflationary depression of 1920-21 that followed was short, sharp and self-correcting.

In today’s post Great Recession environment, fear still persists that the economic ship has not been righted. The duration of a housing bust has been long given the duration of the over-built houses that still dot the landscape in some places.

Central banks are reluctant to take their foot off the proverbial gas pedal and, instead, push the pedal to the metal. And they, still with faith in the Keynesian multiplier, apply ever-cheaper credit (if that is any longer possible).

So where has the money induced boom arising out of the central banks QEs been hiding? To pick up the trail, all one needs do is follow the deflating prices of what is over-built. That leads us to oil, and much the same can be said about commodities in general, especially in the emerging nations.

During the boom phase in the U.S., oil drilling and extraction have been highly instrumental to the U.S. cyclical recovery.

The oil boom didn’t quite take the overall U.S. to a giddy boom, unless you were in Texas or North Dakota or a few other states but its contribution to spending of $300 to $400 billion per year has been the difference between a 2 percent real growth rate and an economy being dead in the water.

Furthermore, as reported by the Manhattan Institute, the economy’s employment growth has been highly concentrated in the oil and gas industry (with other sources of employment growth barely moving the employment needle).

As it turns out, the shale oil industry mainly via the energy investment banks of the region financed over $1 trillion — or an amount equal to approximately 40 percent of Fed-provided liquidity during the Great Recession.

Bloomberg reports that there was $353 billion of IPO in the industry, $286 billion of joint ventures, and $786 billion in lower rated bonds financing this capital intensive undertaking.

Now the oversupply of oil from their success has turned against the drillers. The U.S. marginal increase in oil and gas production to global supply along with generally softening economies in the developed world has caused oil prices to decline in the neighborhood of 50 percent. This boom is now in the bust phase, and additions to production are in retreat.

This represents a world of hurt for the investing entities (generally small firms) and their employees as well as those who hold the energy securities in the form of low-rated bonds or commercial bank loans. Fortunately, the amount does not threaten the mainline financial institutions that hold only a small portion of them, so the financial bust is confined but the physical remains of the boom are silhouetted on the landscape as shown above.

But there is a silver lining to this boombustology. For one, the active life of a fracked well is in the neighborhood of two years during which time 90 percent of product is extracted. The short duration of the income stream from fracked wells allows for a smoother adjustment on the downside and re-fracking will only continue if supported by price increases.

But more importantly, the 50 percent price decline for energy which is used by all other sectors of the economy is provides a large cost savings that is equivalent to a tax cut. Moreover, for the corporate sector, the cost savings represent an increase in net cash flow and higher profit margins and hence broad market support for both stocks and bonds.

But the real issue is will the economy shift gears and sustain the growth of recent years in the absence of an oil thrust? The now-50 percent increase in bank lending to commercial and industrial uses since the bottom of the Great Recession in 2009 along with the “energy tax cut,” suggests that the usual mechanisms of monetary policy are beginning to work to sustain economic expansion beyond oil and commodities.

There are all kinds of booms and busts, and this one could well have a silver lining of generalized higher income after energy costs across the landscape, without a generalized financial meltdown. All in all, the oil and commodities booms and lower prices, even with their industry losses have a net positive effect on economic growth, all things considered.

So, on the spectrum of booms and busts this one will likely be more in the category of the self-limiting agricultural deflationary depression of the early 1920s than the housing boom and bust of recent memory.

Indeed, it has been sufficiently underway to cause the Fed to state its intention to end its quantitative ease. Furthermore, now that there is a stated intention to shift to a monetary tightening, it raises the question of what is left of growth in the US economy without oil expansion? The oil and commodity bust leaves us with a tilt toward deflation and an expansion that remains to be seen.

 

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.
 

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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