Oil prices, opportunistic Saudis and a desperate Putin

By Farrokh Langdana, Director, Executive MBA Program & Professor of Finance and Economics  

Faculty Blog: http://www.business.rutgers.edu/faculty/farrokh-langdana

Back in the day, oil price movements were treated as exogenous, related to outside economic factors. Energy-driven inflation was “commodity inflation” or Cost-Push inflation caused by turmoil in the oil-rich Gulf.  As oil supply dropped (the supply curve shifted to the left) oil prices would spike and global output would be adversely affected. The Cost-Push inflation caused by the supply curve being pushed back, was countercyclical — as P (oil prices) increased, Y (global output) fell.

Then “China” happened, followed by India and Southeast Asia. We all know that story.  After two thousand years as a global macro power, China “went to sleep” for 250 years and then woke up again in 1979.

With millions of new Indian and Chinese and Southeast Asian drivers and with thousands of new global supply chains suddenly powering to life, oil and gas consumption soared.  Oil now became a demand-side story — it became a proxy of business activity, not just a supply curve phenomenon.  In other words, oil now resided in the Aggregate Demand curve as part of Consumption and Capital Investment.

Oil prices became procyclical — as the global demand increased (moved to the right) global output increased and so did oil prices; as P increased, Y increased too, hence “procyclical.”  Consequently, as global activity fell, so would oil prices, and vice versa; oil prices became a proxy for the macroeconomic health of the planet.  In our language, the most important change was that oil prices became ENDOGENOUS — driven by internal developments. And not a moment too soon.

With the US as the biggest producer of oil now, and with this new-found endogeneity (an unexpected variable to the equation), the oil-rich Gulf countries can no longer manipulate the planet’s economy by simply changing the number of barrels of oil they pump out of the ground.

Back in the day, the opportunistic Saudis would deliberately increase supply just when we would be gaining traction in another energy source — solar, wind, and later, fracking — and the subsequent drop in oil prices would grind any new US/Euro/Indian attempts at alternate energy, to a reluctant halt. The new lower oil prices would make any alternate sources of production “more expensive” now that the crude oil prices were artificially depressed. As the development of solar/wind/fracking shut down, the Saudis would again hike the prices…..and the same sordid cycle would continue.

But, mercifully, that is all over. Endogeneity trumps everything. As recent events demonstrate, pathetic attempts by the Saudis to curtail oil supply and push prices artificially up, did nothing. Joy was unconfined! Long live endogeneity. Let the markets rule!

Now to Desperate Putin. In terms of global geopolitical “ordnance”, once oil falls below $60 a barrel, Putin cannot afford any misadventures like Georgia or Crimea. His oil-driven economy runs out of gas (pun intended) and his tanks stay at home. Brent Crude today (11/18) is about 67 bucks a barrel, and falling…..joy is again unconfined.

But then why is oil falling?  Could global macro activity be dropping, or is it due to an oversupply of oil/gas now that the US fracking is powering up again?  Even if it is a combination of the above, then it indicates a slowing global planet. We may see more hot capital inflow flowing to the U.S. thanks to our ‘safe cave’, and this may keep the long end of our yield curve suppressed even as the Fed pushes the short end interest rates up to prick the speculative asset price (SAP) bubble in equities.  We should know soon.

Until then, Welcome to the Powerhouse.