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Central Banks' Balance Sheets, Interest Rates and the Oil Price

In this post I present a more detailed look at developments in central banks’ balance sheets, interest rates and the oil price since mid 2006 and as of recently.

Paper and digital money are human inventions. Most people truly believe it is money that powers the society and their lives because they have never had reason to think otherwise. Money does not create energy, but it allows for faster extraction from stocks of energy (like fossil fuels) and influences consumers’ affordability of energy.

It is humans’ ability to use external energy that gives humans leverage over other animals. The financial system in general does not recognize oil for what it is, it treats it like another commodity.

We (the aggregate human hive) moved to use more financial debts as a way of pulling resources for consumption (like oil) forward in time when Limits To Growth (LTG) was written. In recent years global credit/debt creation went exponential. The workings of financial debts (created “ex nihilo”) was not included in LTG and the effects of debts are rarely recognized when Gross Domestic Product (GDP) is estimated and its future trajectory projected.
 
This post takes a closer look at the question:

“Could the cumulative effects of the strong growth in oil prices starting back in 2004, which signaled a tighter oil supply/demand balance, upon working their way through the economies, have contributed to forcing the central banks’ to deploy their tools of lower interest rates and growing their balance sheets - measures which have mitigated some of the effects of higher priced oil?”

It is recommended to read this post as an extension to my post “Global Credit growth, Interest Rate and Oil Price – are these related?” where I showed that apparently something fundamentally changed in previous mid decade.
 
Data from the big western central banks, US Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) have been lifted from the article “Chart Of The Day: The Fed (And Friends) $10 Trillion Visible Hand” which recently was published by Tyler Durden at ZeroHedge.
Figure 1
Figure 1: The chart above is a composite of two charts. The bottom chart shows the developments for the total central banks’ assets on the balance sheets and the interest rate for Federal Reserve [Fed], European Central Bank [ECB], Bank of England [BoE] and Bank of Japan [BoJ].

Developments in total central banks’ assets in US$ Trillion are shown by the green line and plotted versus the outer right hand scale.
Developments in the interest rate (%) are shown by the dark blue line and plotted versus the inner right hand scale.

On top of the chart and with synchronized time axes is overlaid the development in the oil price (US$/Bbl, Brent spot), red line and plotted versus the left hand scale.

Since the start of the global financial crisis (GFC) in 2008 the western central banks (Fed, ECB, BoE and BoJ) have grown their total assets above $10 Trillion and added around $7 Trillion to their balance sheets in the last 7 years.

The overlay with the developments in the oil price on the chart with central banks’ (CBs) balance sheets and interest rate (ref also figure 1), creates the impression that massive CBs liquidity injections and considerable cuts to the interest rate renewed the support for the oil price after it collapsed from its high in the summer of 2008.
 
The oil price has remained fairly stable since 2011 (around US$110/Bbl) as the western central banks continued to expand their balance sheets at an annual average rate of around US$1 Trillion and kept interest rates low. Then add the expansive credit/debt creation of other big economies, like Brazil and China, during this same period.
 
The fractional reserve system (which creates money/credit “ex nihilo”) has never (to my best knowledge) experienced a situation where total global credit/debt has reached such levels relative to the world’s productive capacities. The fractional reserve system, credit/debt and interest rates are all man-made constructs.
 
Figure 2
Figure 2: The chart above has been lifted from a recent article at ZeroHedge (linked above). The green line in the chart shows total central banks’ assets [outer right axis] in US$ Trillion. The blue line [inner right axis] shows developments in the interest rate, %.

Things looked dark in 2008 so the people in leadership positions asked; “How can we stop this from imploding?”.

The charts (ref also figures 1 and 2) show what any reasonable person charged with “do whatever you can to get us back to prior trajectory” would have done.
 
Each time we do this we make the ultimate reckoning between artificial and real capital worse.
 
Lowering interest rates provided some financial relief for struggling consumers with debt. This also increased government revenues and at the same time reduced their costs for servicing the growth in their total debts.
 
Figure 3
Figure 3: The chart above shows the developments in the oil price [Brent spot] and the time of central banks’ announcement/deployment of available tools to support the financial markets which the economy is dependent on.

The financial system has by others been compared with the operating system for a computer.

NOTE 1: The Fed sets the Federal Funds Rate which greatly affects financial interest rates.

NOTE 2: The chart only shows the timing of major moves from the Fed. This was to avoid crowding the chart with information.

This approach was chosen for designing the chart due to the size of the US economy, together with the fact that the US$ serves as the world’s dominant reserve currency and the western central banks coordinates their efforts.
  • From mid 2006 to mid 2007 the central banks’ interest rates were gradually set higher during which period the oil price temporarily moved lower.
  • By September 2007 central banks started to cut interest rates and expand their balance sheets which coincides with the exponential growth in the oil price with its apex in the summer of 2008.
    The strong growth in the oil price during 2007 and first half of 2008 has all the signatures of the formation of a bubble. And what happens to all bubbles is that they at some point bursts, and this one was no exception. Speculators may have discovered a tight supply/demand balance for oil and motivated from cheaper and more available credit taken advantage of these circumstances.
    A possible cause for the collapse of the oil price may have been that the financial system became liquidity starved, draining funds away that lowered support for the oil price. As far as supplies acts as a proxy for demand, supplies declined around 3% from July to December 2008 (refer also figure 4) while the price dived 70%.
  • In early October 2008 President Bush approved the Troubled Assets Relief Program (TARP) [ref also figure 2 and the sudden increase on the central banks’ balance sheets]. This happened simultaneously with a substantial cut to the interest rate which became lowered from 3.5% to 1.0%. The Fed (in concerted efforts with other central banks) started a program of quantitative easing (QE1), a tool involving assets/bond purchases, increasing money supply and thus providing liquidity to the economy.
    As the financial system is virtual and thus highly responsive, it should be expected that critical movements in it will become noticeable in the real world with some time lag.
  • At the turn of the year 2008/2009 the oil price started to move higher after it had hit a low late in December 2008. The liquidity injection from QE1 (and other central bank interventions) may have recovered support for the oil price. From figure 2 it can be seen that the central banks grew their assets by around $3 Trillion during these months.
    Note in figure 1 how the oil price and with some time lag started to grow after the massive growth of the central banks’ balance sheets and the deep cut in the interest rates.
  • On November 2010 the Fed announced a second round of quantitative easing (QE2) buying $600 Billion of Treasury securities by the end of the second quarter of 2011.
    This coincided with a period where the oil price grew to $110/Bbl.
  • In September 2012 a third round of quantitative easing (QE3) which was open-ended was announced by the Fed. During QE3 the oil price has remained stable at around $110/Bbl and appears only influenced  from effects of seasonal demand variations.
  • In December 2013 the Fed  announced tapering which entails lowering their monthly bond purchases with the intention of ending it. Tapering is not tightening though the market may perceive it differently. Tapering may induce a downward momentum for the oil price.
  • In March 2014 the Fed hints at interest rate rise in 2015, six months after it plans to halt its monthly bond purchasing program.
    [I expect higher interest rates (like raising the Fed funds rate) will exert a downward pressure on the oil price.]
Figure 4
Figure 4: The chart above show world supplies of crude oil and condensates [green columns plotted against the right axis] from July 2006 and to December 2013. In the chart is also shown the development in the monthly oil price (Brent spot) [white circles connected by a white line plotted against the left axis]. Both variables have lines added describing the 12 Months Moving Averages.

NOTE: The chart shows the gross extraction of crude oil and condensates and does not show developments in what surpluses (net energy) that becomes available for societies.

World crude oil (inclusive condensates) supplies are at around 76 million barrels per day, which at present prices represents an annual trade of close to $3 Trillion. The world’s annual GDP is now around $70 Trillion.
 
As far as supplies acts as a proxy for consumption/demand the decline in demand during a few months in 2008 was 3%, while the oil price collapsed by 70%. The steep decline in the oil price versus the minor decline in demand suggests the workings of other forces. These forces may have their origins in frozen liquidity pipelines in money markets and shadow conduits.
 
From figure 4 it can be observed that the nominal oil price has been in a slight decline since 2011.
 
Lower oil prices curtails investments in new supplies and thus brings with it the prospects of a decline in the world oil supplies, thus affecting the transportation sector which is paramount for global trade.
 
High oil prices stimulate the oil companies to explore for and develop discoveries that requires a high oil price to meet their requirements for return.
Low interest rates and availability of credit/debt works both sides of the supply/demand equation for oil.
 
High oil prices are widely accepted to negatively affect economic growth. Now however it appears as the world is wrestling with the dilemma of accepting higher oil prices to sustain and/or modestly grow the flow, or opting for lower priced oil (which apparently could be good for the struggling consumers and economies) and thus running the risk that world oil supplies would start to decline and accept to live with the consequences from what that would entail.
 
From what has been presented so far in this post and my earlier post on this subject, one could be led to believe that higher priced oil has been a contributing factor that forced the central banks’ policies for interest rates and the asset growth on their balance sheets. That leads subsequently to the question:
 

“Could the cumulative effects of the strong growth in oil prices starting back in 2004, which signaled a tighter oil supply/demand balance, upon working their way through the economies, have contributed to forcing the central banks’ to deploy their tools of lower interest rates and growing their balance sheets - measures which have mitigated some of the effects of higher priced oil?”

The debates about the causes and effects of/from high oil prices will continue.
 
WHAT IS THE SHAPE SHIFTING OF THE FORWARD CURVE TRYING TO SIGNAL?
The chart below is lifted from a Morgan Stanley report, which was presented in the article “Everything You Wanted To Know About Global Oil Fundamentals (But Were Afraid To Ask)” which appeared on ZeroHedge.
 
Figure 5
Figure 5: The chart above has been lifted from a recent Morgan Stanley report and shows how the forward curve for oil [Western Texas Intermediate; WTI] has evolved since 2010 and as of March 2014.

NOTE: The forward curve is a poor predictor of actual prices in the future. The forward curve however reveals market sentiment.

Stock indices are, well stock indices, and may be a poor reflection of the true state of the real economy.

The shape shifting of the forward curve (or futures curve) in figure 5 is interesting as it has morphed from a steep contango in 2010 into gradually steeper backwardation.
 
A futures contract is an agreement between two parties for delivery of a specified amount of a commodity at an agreed price with payment at the delivery date. A futures contract is a mean for  producers to sell risk (hedge) to speculators.
 
The shape shifting of the forward curve as shown in figure 5 illustrates a change from optimism to growing pessimism.
 
The steep contango in 2010 (futures prices above prompt) reflects a sentiment for growth and it is worth noticing this comes after the deep cuts to the interest rates and as the central banks had added close to $3 Trillion of liquidity.
 
For some time I have been monitoring the future curves for oil and natural gas. Oil and gas fuels the real economy and should thus be better indicators for future expectations for economic developments.
 
A steep backwardation (with a considerable price spread between prompt deliveries and deliveries at some future point) becomes discouraging for the producers as a mean to lock up future revenue streams. At some threshold, it becomes challenging for some oil producers to ensure adequate revenue streams for the expensive to extract oil in the futures market. A steep backwardation takes away some of the predictability oil companies rely on.
 
WHAT ABOUT OIL/GAS COMPANIES?
Oil/gas companies are operated by humans. Humans are conditioned by the hive(aggregate societal pursuit of surplus, and recently surplus “value”) in whatever way they can.
 
The global tight supply/demand balance for oil, an apparent structurally higher oil price and demand growth (both supported by low interest rates and available credit) provided the impetus for the oil companies to take on more debt as their net cash flows (post dividends) did not suffice to finance these developments.
 
The major oil companies have in recent years witnessed their oil production decline and been struggling with financial returns.
 
These strategies from the oil companies were in reality a bet that consumers (private and public) would be able to continue to go deeper into debt and/or draw down savings {even resort to “money printing”} to pay for the more expensive oil.
 
For some time my view has been that the more expensive Arctic, shale, deep water, whatever oil is strongly linked to consumers either have improvements in their purchasing power and/or are able to take on more debt.
 
Low interest rates certainly ease debt services (direct {private} and indirect {sovereign}) for consumers, but seen in conjunction with declines in real disposable incomes, these measures moderately and for some time improves affordability for expensive energy (oil).
 
In some way consumers and oil companies are competing about access to the same debts/credits. Consumers to be able to continue to afford higher priced oil. Oil companies to be able to bring more expensive oil to the markets.
 
 
Companies now report they have record amounts of cash while their debts has grown faster. Oil companies took on more debts to sustain a high level of CAPEX (CAPital EXpenditures) to develop the more expensive oil.
 
If oil prices for some reason or combinations of reasons becomes noticeable lower for some time, a lot of oil companies will struggle to maintain CAPEX as the effects of servicing a higher debt overhang will further constrain their development plans.  At some point focus may even shift to deleveraging.
 
Oil/gas companies are in business to make as high financial profit as possible (public companies are obliged to pursue this strategy). Before funds are committed to a project/development, it is subject to extensive analysis to document that it meets the companies’ requirements for returns (normally 7 – 10% post tax). Oil companies are now raising the hurdle for the breakeven price they require for developments before they commit to fund them. Some oil companies now openly express concerns about their abilities to finance future commitments (developments to be sanctioned) from free cash flows.
 
Oil companies are now resorting to asset sales, which enables earnings/profits to be pulled forward in time and use the proceeds to finance ongoing developments.
 
SUMMARY
To me the evidence strongly suggests that in recent years there are ample relations between the oil price, central banks’ interest policies of keeping rates low and the strong growth on central banks’ balance sheets.
 
Money can be looked at as a marker for energy (alternatively; money is a claim on energy). As energy prices rise and/or energy supplies decline, this will depreciate the purchase value of money (and other paper constructs representing money).
 
No central bank can print barrels of oil!
What central banks can do is for some time alleviate some of the strain on consumers from high oil prices by keeping interest rates low and inject liquidity into the financial system. Any well intended measure seems to come with unintended consequences. As the transmission mechanism for the added liquidity for transfers of money into the real economy does not work as hoped, surplus liquidity in the system is used in search of higher yields and thus ends up bidding up asset values, for carry trades and others.
 
Depletion of oil reservoirs (stocks) and its derivative, declining flows from oil wells, never sleeps.
 
I am not convinced that those who wish for lower priced oil (thus lower gas prices at the pump) are deeply aware of what they really wish for.
 
Low interest rates and debt growth (now by sovereigns and “money printing”) are the systems’ response that for some time will abate the effects of higher oil prices.
 
This looks like temporarily bending The Second Law of Thermodynamics, which is incorruptible.
 

“The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts.”
  – Bertrand Russell
 
“If society consumed no energy, civilization would be worthless. It is only by consuming energy that civilization is able to maintain the activities that give it economic value. This means that if we ever start to run out of energy, then the value of civilization is going to fall and even collapse absent discovery of new energy sources.”
-  Dr. Tim Garrett, University of Utah

Oil money image via shutterstock. Reproduced at Resilience.org with permission.

Editorial Notes: Since Rune published this post at his blog the European Central Bank announced new measures including a negative interest rate. Here are some takes on that move:
Alasdair Macleod: All You Need To Know About Negative Interest Rates
Debt Rattle Jun 8 2014: The ECB Negative Rate Is A Dud
Mario Draghi takes historic gamble with negative rates but still stops short of QE

What do you think? Leave a comment below.

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