Thursday, December 3, 2015

Fundamentals Rule

Just a thought.

Much of the glut of oil that has accumulated has been due to the long period of low interest rates and the way that this has enabled cheap exploration and easy drilling and other investment in production of products that otherwise would not be economical. But the cheapest oil comes from the traditional sources, still, and OPEC is desperate to keep the cash flow. The Saudi's to support their welfare society, and other smaller producers with the need of cash to survive the slowdown in Chinese demand that also impacts overall supply. So the price of oil declines as the glut in supply persists.

And this comes at a time when the "new technology" producers, to coin a phrase(?),(the frackers and miners) are increasingly needing profits to pay off the debt they have undertaken. Junk bonds are pressured and banks that hold that debt will be pressured. And of course we are getting to the point where wages are starting to rise, economic growth seems to show signs of life, and interest rates are under pressure to rise, if not just because the rise is 'overdue' from a policy standpoint, but perhaps in the case of high yield debt, due to the increased risk of the debt itself. We may see another example of reflexivity where interest rate rises increase the risk of defaults which causes interest rates to rise... etc.

If this scenario plays out it would lead to increased volatility in asset prices and increased volatility in derivatives. Near the end of the process, of course, would be decreased production of energy, rising prices of energy, and thus more reason for interest rates to remain high.

So, the fundamentals of supply and demand will always, in the end, remain supreme. It may be that the cheap oil will have to be exhausted before the world can move on to the less efficient energy. And that means we have been fooled by low interest rates that have led us to believe we could grow our economy on other sources of energy that does not have the energy ROI that led to the last 100 years of rapid growth.

Wasn't that cheery?

Control risk,

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