Your Guide To Operation Twist, Oil Prices And More!

What a week, last week! Gold prices were down. Silver prices were down. Oil prices were down. The broad stock market moved north early last week, then headed south. Today it’s continuing the downturn…

The headline explanation last week was that the Federal Reserve announced a continuation of “Operation Twist.” (Who thinks up these names?) That is, the Fed will expand its previous program to replace short-term bonds with long-term debt by targeting another $267 billion through the end of the year.

According to the Fed money gurus, swapping short-term bonds with long-term debt will reduce unemployment and protect the economic expansion. Yes, they said that.

Protect the economic expansion? Huh? When I open the newspaper, I see stories about retailers closing stores and laying people off. The cynical explanation is that people go to brick-and-mortar stores to peruse the goods. Then they order things cheaper on the Internet, and often don’t pay sales tax. This is a structural issue, and the Fed won’t fix the problem with long bonds.

Then there’s the so-called “Facebook Flu,” which is shorthand for the inability of new businesses to raise capital. Nominal interest rates might be low, courtesy of the Fed. But regulations and tax rates are relatively high, courtesy of the rest of the government. The bottom line is that the U.S. is uncompetitive in a world of mobile capital.

Meanwhile, big media are fixated on stories about jobless, indebted college grads living in their parents’ basements. And don’t neglect the terrible fact that minority citizens and veterans have South African-level unemployment rates north of 25%.

But out in Fed-World? The answer is to stick with Operation Twist — which, from all appearances, didn’t work so well the first time. This reflects the curious logic of modern governance, that if something doesn’t work we’ll just continue and do more of it.

It all prompts me to recall an old line from my Navy days: “Beatings will continue until morale improves.”

That’s the Story, and We’re Sticking to It!

Let’s stay on this point. The Fed has a story, and it’s sticking to it. According to a Fed statement, continuing Operation Twist “should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative.”

I love it when economists get lawyered-up. Operation Twist “should” keep interest rates down? And make “broader financial conditions more accommodative?” For whom?

Actually, Operation Twist is merely a policy under which the Fed keeps interest rates low to facilitate long-term government borrowing. Thus is the Fed taking care of the needs of big government — for a while, anyhow. There’s nothing on the table for the wealth-creating side of the economy, which is where policy needs to go.

And what about the stock markets? What about investors? Where’s our free money from the Fed? Last week, the Fed didn’t say anything about increasing the money supply. There was none of that “quantitative easing” (QE) thing.

Along those lines, the market was poised for disappointment. Like Pavlov’s dogs, the markets have become conditioned to QE — free money, sort of. And when the Fed doesn’t come through? People hit the sell button.

Defying the Business Cycle

Let’s discuss a curious conceit of modern monetarism. It seems that governments everywhere — the U.S. government and many governments across the world — have decided that they can avoid recessions by tweaking monetary policy.

You constantly hear the big-league monetary guys talking about avoiding “another Great Depression.” The Great Depression is the shiny object to which monetarists always point. Nobody wants a repeat of the 1930s, right?

Notice how you never hear Fed policymakers talk about avoiding another “recession of 1920-21.” That was the global recession due to massive economic contraction right after World War I.

In the U.S. and abroad, post-World War I, government spending fell dramatically. Millions of mustered-out soldiers hit the streets. The world economy — certainly in devastated Europe and post-revolutionary Russia — was wrecked on the rocks. Plus, the world had just suffered the Spanish flu pandemic, which killed millions.

Things got very bad in 1920-21. In the U.S., industrial output plummeted. Tax receipts fell off a cliff. Agricultural prices declined. Unemployment was 25%, according to the statistics of that era.

And in the U.S., what was the response of the administration of then-President Warren Harding? The U.S. government — most of whose employees worked for the Post Office, back then — did almost nothing. The recession ran its course over about a year, and then the U.S. economy took off for the rest of the 1920s — until the Fed and Herbert Hoover screwed things up in 1929.

Whatever the significance of the 1920-21 model, it doesn’t seem to pertain these days — not to the current managers of the money supply. It’s always the 1930s model that applies. When there’s an issue, the government has to do something — preferably big — and that something seems always to be along the lines of interfering with the business cycle.

Thus, at the first sign of an economic downturn, central banks — aka “government” banks — lower interest rates. Again, the idea is that all a downturn needs is low interest rates, and voila! Things will fire things back up again — just like in the 1930s. (Oh, wait, that’s not what happened in the 1930s.)

Then again, aren’t low interest rates just another means of mispricing credit across an entire national economy, if not internationally? Doesn’t holding down the cost of credit — to below the market rate (meaning the rate at which a free market would set the price) — just mix up a recipe for eventual disaster? We’ll doubtless find out.

At root, the Fed’s low interest rate policies discourage savings and reward consumption. Indeed, the Fed is punishing savers and investors out in the real economy (c’mon, you know what I mean!), while subsidizing speculation and financialization.

Hydrocarbon Gluts

Now let’s change gears. Do you recall the natural gas glut in North America? It’s hard to miss. Too many operators drilled too many shale gas wells, and the resulting supply of new natural gas has driven prices down into the cellar.

At the micro level, operators are in a quandary. Do they stack the rigs, furlough the recent hires and wait it all out? Or what else?

Consider this. If many operators don’t keep on drilling, they risk losing a lot of leases that are coming up for renewal — and that’s a lot of money down the drain. Or do they keep poking holes in the ground, looking for low-cost commodity hydrocarbon molecules? Drill the wells — slowly — and hold the leases. That, and pray for higher prices.

One move has been that many operators switched from drilling for “dry” natgas (aka methane) to “wet” natgas, which contains natural gas liquids (NGL) like ethane, propane and butane.

So now there’s a glut of NGL! Prices for ethane, propane and butane are down at modern lows. There’s talk of some U.S. operators literally giving away NGL, just to clear the pipelines.

Meanwhile, in the world of raw crude oil, Saudi Arabia has been pumping flat-out — way over 10 million barrels per day (Mb/d). This is at least one Mb/d over and above the usual output from Saudi Arabia. In other words, the Saudis are pumping oil from their strategic reserve of spare capacity.

The initial reason for the Saudi excess, a few months back, was anticipation of sanctions against Iran that would bottle up Iranian oil exports. Saudi Arabia wanted to keep the world markets “well supplied,” in that famous phrase that the Saudi Aramco people use all the time.

Does this “extra” Saudi oil still make sense? Sanctions may be hurting Iran, but the waves are blowing back into the rest of the world as well. When you combine the crude oil supply with all the excess gas and NGL moving about, the result has been a severe, short-term disruption in energy markets.

Last week, Brent oil prices plunged to less than $89 per barrel, while West Texas Intermediate (WTI) broke below the $80 level. These are 18-month lows, and all amidst the above-discussed economic gloom.

Indeed, I’ve seen even gloomier predictions for oil prices than the current postings (“gloomier” if you’re a producer, not a consumer). For example, Credit Suisse has forecast $50/barrel. If that’s the case, expect to see lower share prices for oil and oil service companies.

At the same time, low oil prices are not necessarily an economic panacea. FedEx, for example, uses lots of jet fuel, yet it’s forecasting lower future economic activity based on who is (and is not) shipping goods across the globe.

In the U.S., the steel industry is forecasting lower demand as well — less steel for housing, large construction, autos and much more. It’s not a pretty picture.

Where Are We Heading?

So we have lower and lower energy prices, yet the world economy appears to be slowing. Low interest rates haven’t worked all that well, yet the Fed will keep throwing lowballs. Where is it going? How long can this last?

I’m not running a day-trading service here, but I won’t criticize anyone who tries to trade around the oil price decline. That is, sell at $80 per barrel and buy back in at $50 per barrel — if you want to believe Credit Suisse.

My view is to watch and wait. Ride through the storm, because we won’t know when we’re at the bottom until after we’re in the rebound.

My view is also that “low” oil prices can’t last long. Remember that chart I showed you a few weeks back, on May 24? The data come courtesy of Pierre Sigonney, chief economist of the French oil giant Total.

The chart describes the oil price level that a series of major producers require in order to balance their national budgets. The dark-shaded region at the bottom is the “break-even cost” for producers, per data of Total. The lower shading reflects how much it costs to lift barrels of crude oil out of the ground.

Many producers lift oil at an overall cost of $10-20 per barrel. Indeed, most of the world’s daily oil supply — 45 million barrels out of the world’s daily output of about 72 million barrels — comes from operations that cost under $40 per barrel average for production.

But take a look at that upper-shaded area, the “budget break-even” line. That’s the price point at which a long list of petro-players has to sell their oil to fund their national spending. Without this oil price, there’s not enough money to import food and other consumer goods, let alone to pay for the army and secret police — or the palaces and fancy jets.

It gets back to the question of how low oil prices can go. WTI at $80 and Brent hovering under $90 is the threshold of financial pain for the world’s largest oil-producing nations.

Again, as I’ve said over and over here and elsewhere, the big-name oil-producing nations are pulling “legacy” oil out of the ground. That is, they’re mostly lifting oil from fields that were discovered in the 1960s and 1970s, and developed in the 1980s and 1990s. How much longer can it last? We’ll likely live long enough to find out.

Thanks for reading. Best wishes…

Byron W. King

Your Guide To Operation Twist, Oil Prices And More! was originally featured in The Daily Resource Hunter. Check out the newest Daily Resource Hunter research video “The Price of Gas Explained”.

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