In mainstream economic thought, there is one primary way that the economy can go screwy. Prices can rise too fast, and this is called bad inflation. This is to be contrasted with good inflation, when prices are rising at the Goldilocks-just-right rate. Diehard Keynesians (and monetarists) do fret about falling prices. But as Ben Bernanke’s infamous “helicopter money” speech demonstrated, they think that if you increase the quantity of money fast enough you’ll never have falling prices.
Our view is that falling interest rates cause falling prices because each drop in the rate is an increased incentive for producers to borrow to add capacity. The interest rate has been falling for nearly 40 years, which has been a long time of rising incentives to produce more and more. And, it worked, bringing enormous capacity in the form of American shale oil.
In our view, spreads more often than prices are where one should look to see signs of economic damage. Think of it as a fissure in the gold market when, for example, the bid-ask spread blows out from its normal $0.20 to $20. Or, if the carry in gold is $51 an ounce from late March to June.
Today, however, we witnessed not only a crude oil spread, but price blow out. The price of the May contract which delivers oil as soon as tomorrow dropped to -$38. In other words, they would pay you to take oil off their hands. In a certain sense, the explanation is simple: only people with storage tanks could buy oil. Financial speculators are confined to owning paper oil such as futures contracts. Today, that latter group was forced to sell at any price.
Of course, the proximate cause for the carnage in crude is the drop in demand due to the economic lockdown. Neither those who are working at home nor those who are laid off are commuting to work anymore. Trucks that would be delivering clothing to clothing stores and toys to toy stores are not rolling. With less demand for crude than before, there is bound to be a surplus. However, the roots of this particular glut go deeper.
The fact that, for the first time ever, the price of oil for immediate delivery hit -$38 a barrel should be motivation enough to look deeper.
There is another way to look at the crude market, and that is the spread between spot and futures (i.e., the oil basis). At the time that the May contract hit -$38, the June contract was +$21. One could buy spot and sell future. Today, that would have earned you $58 a barrel. But only those who have storage tank capacity can play.
Regular readers will know that this condition when the price for future delivery is greater than the price of spot is called contango. A high contango means that the commodity is in surplus. Think of it this way, the highest and best use of crude today is to put it into storage.
Keep in mind that the arbitrager who takes that $58 spread has no price exposure and is not betting on price. He has locked in both his buy price and sell price. He cares only about spread. It is the speculator who’s buying the next contract who is betting on price (and this guy may be in for a rude awakening).
Of course, small shortages and gluts can occur for any number of reasons. But the thesis of Keith’s dissertation is that every government intrusion into the markets necessarily causes discoordination. For example, if you see hundreds of millions of people wanting for restaurant meals, cocktails, haircuts, and sports entertainment while tens of millions of people wanting for jobs providing those things, then you have observed a great discoordination.
Oil producers have consumed good capital to produce a commodity that was so unwanted that buyers had to be paid to take it. Just as we know that the cause of the Great Unemployment is government, the same is true for this disaster in oil. Only government could force interest rates down for four decades. Only government could turn off the economy.
Keynesians and socialists (but we repeat ourselves) may cheer the wonderful good news for consumers. However, Bastiat encouraged us to look not just at what is seen, but the unseen also. What is not seen is the destruction of capital by the oil producers and their vendors, the losses to investors and lenders, and of course layoffs are coming to the oil patch. We would bet an ounce of fine gold against a soggy dollar bill that at least one financial trader was taken out in a body bag today.
The productive capacity of the oil industry must be matched to the demand for oil. Since demand has been destroyed by government lockdown orders, supply will be destroyed if the lockdown is not soon ended. Projecting forward, the logical consequence will be a skyrocketing oil price when demand picks up (this will be called inflation, and Quantity Theory of Money Believers will say “see, inflation, just as we predicted.”) Once destroyed, productive capacity will be difficult to recreate.
We would make one more point. We’ve said many times in the past that the marginal utility of gold does not diminish. That is, despite that all virtually all of the gold mined in human history is still in human hands, the market happily absorbs the next ounce of gold produced at the margin, on equal terms to all the others. This proposition is controversial because people assume marginal utility must diminish as quantity increases (thus, the persistent belief in the Quantity Theory of Money despite epic price collapses amidst epic money printing episodes).
But sometimes, to understand an economic principle, it’s easiest to think of yourself as the actor in the market. We would wager an ounce of fine gold, that you would be happy to accept another ounce of gold, but not a barrel of crude oil. The gold, you could put in your pocket. The barrel of oil, well, where would you put it?
On social media, someone responded to Keith’s post about this by saying he wished he had a swimming pool. Our response is that oil is smelly, toxic, and it degrades with exposure to oxygen and sunlight. In other words, the marginal barrel of oil really is worth less than the previous. Especially when market participants run out of storage capacity.
Those who would think to back some kind of cryptocurrency with oil or other commodities should take note.
© 2020 Monetary Metals