(R)oiling the World Markets

 The world depends on oil for many things, making it one of the most important commodities around.  So, let’s consider some of the effects of a 40% drop in oil prices during the last six months:

  1. The cost of doing business just became obviously cheaper for many businesses; i.e., anything involving transportation of goods/people.  This could boost many business profits in the short run…but that’s not the whole picture.
  2. As business performance improves, the Fed may react by raising short-term interest rates because part of the economy is doing relatively well.  An increase in interest rates could have a rippling/dampening effect on the markets and the economy in the medium term, not to mention the ever-rising debt service expense incurred by various governments around the world.
  3. The marginal oil producers (read: fracking, oil sands, deep water wells, and recent high-cost producers) will feel the pinch in their profits in the short run, causing many of them to shut down.  A rippling effect would inflict pain on lenders who lent money to those producers, investors in those producers, as well as the derivatives industry, where losses can be amplified with the use of margin.  In time, without the marginal producers, oil prices will rise encouraging the marginal producers to re-enter the market, if they can.
  4. As with any significant price move in a strategic asset, there will be major turmoil for at least half of the parties involved in that industry.  In the medium run, if oil prices remain relatively low, the Fed may step in to bail out the essential U.S. oil industry participants with loans that effectively transfer ownership of marginal producers to the Fed, keeping them on life-support as long as possible or until they become profitable once again.

But, what if the losses in the oil industry are too large for the Fed to cover, or, more likely, the Fed’s balance sheet balloons beyond a “reasonable” amount?  What would happen then?  Inflation from excessive money printing?  Deflation from the lack of spending due to the need to repay tremendous debts?  Hard to say in the short run, but my money is on inflation in the long run.  Whether we can make it through possible deflation in the short run to get to the inflation is another matter.

Ah, the problem of investing in a government-manipulated economy!  If it’s not the Fed, it’s the plunge-protection team buoying up prices through the futures markets, or some foreign government’s purchases/sales of oil, or gold, or corn, or whatever.

Get ready for more of the mal-investments that come with government manipulation/intervention.

Robert Jackson Smith

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