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Consumer boom or commodity bust?

That is the question. And the answer is very likely both. The global commodities rout – which began with coal, has worked its way through iron ore and grains, is now hammering oil, and appears likely to take down industrial metals next, most notably copper – is shredding expenses for global consumers.

Where central banks have singularly failed to stimulate households with their rounds and rounds of money printing, succeeding in inflating commodity prices instead, oil can succeed in handing cash direct to consumers to spend. There’s no saying they’ll spend it given the debt revulsion that dominates much of the Western world still but they’ll have it at least and that’s a start.

The keenest beneficiaries will be the oil net importers including the US, China, Japan, Germany, India, South Korea, France and Italy. Consumers of these nations will see the double benefit of lower energy bills and better external balances, supporting currency, asset and purchasing power gains. It is not a small list of countries and households!

Consumers will benefit in other ways as well. Global central banks will press pause in the prospective tightening cycle, and some will print even more, as inflation tumbles. This is going to fuel liquid asset markets, especially stocks.

The biggest losers are the oil exporters, of course. These include Saudi, Russia, Iran, Iraq, Mexico, Norway,Venezuala, Nigeria, Canada and the UK. In these nations, consumers will benefit but that will be offset by falling capital investment and job losses, as well as eroding external balances, tax receipts and currencies.

A much smaller group thankfully, because if oil falls far enough some will enter crisis as fiscal deficits grow and currency reserves run short. At this stage the leading contenders are Russia, Venezuala, Nigeria and perhaps Iran.

That brings us to the downside of the big move in oil, as well as many other commodities. Because the super cycle has been so enormous, first driven by the demand shock of China then by the currency deflation of Western central banks and in energy by peak oil fears, the supply response has now been just as awesome.

That’s a good thing except it was such an artificially exaggerated cycle that a lot of the investment has been made on massively inflated costs and demand forecasts. These are now going to have to fall leading to asset, debt and equity write-downs of an equally epic magnitude. That means there are going to be defaults and a  lot of bad debt surfacing all around the commodity complex.

It may appear in US bank’s and their funding of the shale revolution. It may be US junk bonds for the same reason. It may be the massive push by the more intrepid global banks into funding commodity expansions in emerging markets. It will probably be all three, combined with some big debt problems in the nations themselves.

At this point it’s impossible to know where the problems will be most intense. But it’s a good bet that they’ll arrive.

As well as commodity sovereigns, the prime candidate for an unwind sufficient in size to represent a “credit event” is US shale. Other energy plays are like Australian LNG, they will lose money on all-in costs that include capital investment, but once the cost of building is written off, and equity takes it in the neck, the refreshed firms (or new owners) will be able to produce profitably.

US shale, however, is different. By its nature, fracking is a capital intensive business ongoing. It needs to constantly spend money to make money as new wells must be drilled, equipped and manned. It needs ongoing capital to survive therefore and much of it has come from the US junk bond market. From the WSJ:

Junk bonds have financed the U.S. shale boom, and now the sharp drop in oil prices could lead to a massive wave of defaults on that high-yield debt.

Should oil prices fall below $65 per barrel and stay there for the next three years, Tarek Hamid, a high-yield energy analyst at J.P. Morgan Chase & Co., estimates that up to 40% of all energy junk bonds could default over the next several years.

Energy companies, the fastest-growing segment of the high-yield bond market in recent years, account for nearly 18% of all outstanding high-yield bonds, up from 9% in 2009, according to J.P. Morgan.

Mr. Hamid says that the 40% possible default rate is the upper limit over the next few years, and that energy companies will take steps to avoid falling into bankruptcy, including cutting spending and selling assets.

Quartz has more:

Junk-bond debt in the US energy sector has tripled to $210 billion since 2008, comprising about 17% per cent of the $1.3 trillion high-yield market, up from only 4% a decade ago. All that financing has helped US shale flood the global market over the last couple of years, reaching 4 million barrels a day in 2014, and causing the sharp downturn in oil prices.

Here’s the catch: The drop in prices will make it tougher for energy companies to pay off their newly minted junk bonds. The FT reported last week that a third of energy debt bonds are classified as distressed, meaning there is a high likelihood that will have to be restructured. Some investors in the riskiest forms of energy-related junk have seen their returns hammered to roughly zero (paywall).

As a result, some analysts say the markets could imminently shut offlending to shale oil drillers. Others say the junk bond market might collapse, in an echo of the real estate bubble of the mid-2000s.

That is not so much money and would not be enough to paralyse financial markets. Unless it’s double and triple leveraged and it probably is, via ETFs and other financial magic.

Reuters is reporting that shale permits are already plunging:

Permits for new wells dropped 15 percent across 12 major shale formations last month, according to exclusive information provided to Reuters by DrillingInfo, an industry data firm, offering the first sign of a slowdown in a drilling frenzy that has seen permits double since last November.

“Currently, the market is focused on U.S. shale as the place where spending and production must be curtailed,” Roger Read, a Wells Fargo analyst, said in a note Friday. “There is little doubt, in our view, that lower oil and gas prices will result in lower spending and lower shale production in 2015 to 2017.”

A cutback of U.S. production could play into the hands of Saudi Arabia, which has suggested over the past few months that it is comfortable with much lower oil prices.

“The first domino is the price, which causes other dominos to fall,” said Karr Ingham, an economist who compiles the Texas PetroIndex, an annual analysis of the state’s energy economy. One of the first tiles to drop: the number of permits issued, Ingham said.

So, US shale could implode as price hedges run down and debt costs rise.

To sum up, there are three possible scenarios for global growth as commodities wrestle with consumers. The first is the benign outcome of falling commodity prices shifting income to the global consumer and his/her new spending power drives up demand. That, in turn, resuscitates investment and commodity demand and stabilises lower prices without a collapse.

Second, underway is the complete reverse scenario of that which characterised the build up to the GFC when consumers deteriorated around falling asset prices and the commodity boom rose in their place driving stock markets to new highs on the notion of “decoupling”. We’re now “recoupling”, with the US consumer leading the way in a final business up-cycle that will be undermined over time time by falling commodity assets and debt, which ultimately grows large enough to destabilise markets. Either that, or the stock market bubble rises so high on the consumer relief that it implodes in the medium term, as Jeremy Grantham expects. When that happens the world will find itself without much monetary or fiscal ammunition left to combat the slump.

Third, consumers don’t  spend their new found income, but instead accelerate deleveraging and commodity prices keep falling as well, plunging the world into a deflationary cycle from which it will be very difficult to rescue it.

For me, scenario one is unlikely because I don’t see consumers spending enough and the structural adjustment in China away from investment and building, as well  as the broader energy transformation of the world, will keep pressure on commodity prices until excess supply is wrung out.

Scenario three is too gloomy, I reckon. Boosted consumers will spend some of the dough and the stock market is likely to continue to rise in the US and other consumer markets in something approximating a virtuous cycle.

Scenario two is my pick, so the net result for asset allocation is an exaggeration of the changes already underway in global markets, not any sudden break in trend – flows to US assets increase and emerging markets take it in the neck.

So, good news, bad news, and for Australia more of the latter.  Consumers will benefit, and the the terms of trade will take a caning (though not from oil, because we’re a net importer, at least for now, probably not later as LNG comes on stream). The LNG projects will join iron ore and coal in suffering but households and manufacturing will be spared the income hit from rising gas prices. We’ll also see a falling dollar as commodities generally are sold on the unwind of yesteryear’s commodity financialisation and a stock market de-rating, largely missing out on the gains seen in other consumer markets.

The real issue for Australia will come, as always, with the new global debt shock.

David Llewellyn-Smith

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