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.

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.

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.

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.

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.

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:

The debates about the causes and effects of/from high oil prices will continue.

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.

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

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.

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.

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.

Here’s A Chart You Won’t See On CNBC from Zerohedge.

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.

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).

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.

7 Comments on "Central Banks’ Balance Sheets, Interest Rates and the Oil Price"

Davy, Hermann, MO on Tue, 10th Jun 2014 6:53 am 



The financial system should have corrected in 2008. The whole global system almost corrected and how far that correction would have been is a casino bet. When system correct chaos enters and randomness results. In a complex self-organizing system who knows how far the drop until reboot would have been. Yet, we would have had a better chance of a gradual, softer, and normalized reboot than what we see today. The system today has been forced with corruption, manipulation, debt creation, wealth transfer, and the further and relentless environmental damage. The system today is in severe disequilibrium and forced at a maximum. Such condition have pronounced, severe, volatile, and catastrophic results. In a system correction such bifurcations ensure much infrastructure of the old system is lost through quick and violent entropic decay. So folks we are facing a decent that will be nasty, ugly, and violent. This can happen for any of a number of reasons and any of a number of reasons will destroy confidence and liquidity in the global financial system. All locals rely on a robust functioning global support system. Without this global support system of infrastructure maintenance, energy supplies, food supplies, communication/distribution and command/control our delocalized locals will fail. All the above mention global system attributes are complex and self-functioning and dependent. A failure in one of the above attributes quickly pulses through the system causing failures in the other. We are near a bifurcation of any and all of the above mentioned attributes to the global system and multiple subsets of these attributes. Then throw in WMD, NUK material dangers, and a multitude of dangerous industrial processes and we are looking at a regular time bomb of the worst of the bible. Our best bet is a significant crisis ASAP and a resulting TPTB adjustment in attitude. If the system can hold just enough maybe TPTB will make adjustments in favor of promoting the necessary bottom up mitigation efforts of a post BAU. This is our only chance of some kind of softer landing. Nature will adjust things in a random fashion which most likely will be ugly and messy from a human standpoint.

Aaron on Tue, 10th Jun 2014 7:50 am 



This seems to advocate a slow grinding collapse rather than fast and violent, and I would tend to agree.
Interest rates eventually begin to rise> consumers and oil companies pay higher debt servicing costs> oil consumption reduces> oil price reduces> oil companies capex reduces, ergo we have a slow grinding peak oil.

Davy, Hermann, MO on Tue, 10th Jun 2014 9:13 am 



Mak, there is an old country song by Toby Kieths: “How Do You Like Me Now”

read this Mak and weep:

As everyone who has followed even the simplest Ponzi schemes knows, this is the part of the lifecycle when many tears are shed by most.

http://www.zerohedge.com/news/2014-06-10/chinas-evaporated-collateral-scandal-spreads-second-port

Folks this is a dangerous contagion to watch!

Northwest Resident on Tue, 10th Jun 2014 10:04 am 



The US shale gas bonanza was largely enabled by bubble economics – “low interest rates and easy financings” – but is unravelling as financial wishful thinking hits the wall of production reality, and is already a “commercial failure,” Powers told the IEA. Almost “every player” has experienced “huge debts on balance sheets” and “enormous write-downs of shale gas reserves.”

In 2012 alone, he said, Southwest Energy wrote down reserves of Fayetteville from 5 to 3 trillion cubic feet (tcf); Chesapeake Energy wrote down Haynesville and Barnett proven reserves by 4.6 tcf (erasing 20% of its proven reserves); EnCana wrote off $1.7 billion in shale gas assets; British Petroleum wrote off $2.1 billion due to failed investments in Fayetteville and Woodford shales; and BHP Billiton wrote off $2.84 billion in shale assets – to name just a few.

From: The inevitable demise of the fossil fuel empire

theguardian dot com/environment/earth-insight/2014/jun/10/inevitable-demise-fossil-fuel-empire

shortonoil on Tue, 10th Jun 2014 4:34 pm 



“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?”

We have considered this possibility quite closely. By our model the total energy delivered to the economy from petroleum peaked about the year 2000 (per unit energy delivered X units produced). Production growth had not yet stopped, but its rate fell to where the per unit decline in energy delivered over took the production growth. We hypothesize that when that occurred the economy went into a gradual decline. Debt began to become unserviceable, and Greenspan had to cut interest rates dramatically to prevent further defaults. The economy did pick up as a result, increasing demand for petroleum which began the price cycle rise of 2004.

Somewhat speculative by our standards, but highly possible.

http://www.thehillsgroup.org/

shortonoil on Tue, 10th Jun 2014 4:44 pm 



Aaron said:

“oil companies capex reduces, ergo we have a slow grinding peak oil.”

Chaos Theory informs us that systems become more complex until they reach a point where they fall into a chaotic state. It also tells us that there is insufficient information in the system to tell us when that will happen, or what the outcome will look like.

A slow grinding peak oil, maybe? But I wouldn’t bet on it!

Makati1 on Tue, 10th Jun 2014 8:11 pm 



It’s all about to come crashing down and then it will not make any difference. The game will be over for “for profit capitalism” and all of its sickly kids, like Wall Street, IMF, WB and the Central Banks. What resurfaces after will be barter and trading like before this epidemic of greed started.