Oil’s Uncertain Comeback

Mohamed A. El-Erian  

A man fills his car up with gas at a station

CALGARY – As global economic growth picks up practically everywhere, oil producers are becoming increasingly hopeful that the recent impressive price recovery will continue. But, if those hopes are to be fulfilled, not only will producers have to control what they can (by maintaining production discipline); what lies beyond their control (output from shale and the value of the dollar) will also have to work in their favor.

Just over three years ago, oil (WTI) was trading above $100 per barrel. But, by early 2016, prices had plummeted to around $30 per barrel, owing to a combination of sluggish demand, alternative supply (particularly shale oil and gas from the United States), and a new OPEC production paradigm under which the cartel, led by Saudi Arabia, withdrew from acting as a “swing producer.”

In the wake of the resulting collapse of export receipts and budget revenues, OPEC adopted a new approach, based on a modernized production agreement with two key features: greater flexibility for countries facing especially complex internal conditions (such as Libya) and the inclusion of non-OPEC producers, particularly Russia. Together, OPEC and non-OPEC countries established a floor from which oil prices could bounce. With the pickup in global growth and the emergence of geopolitical uncertainties (which could constrain output in some oil-producing countries), oil prices have rebounded to above $60 per barrel.

The current global growth phase is particularly good for the price of oil (and other commodities), because it is synchronized, real, and, increasingly, self-reinforcing. It is being powered by simultaneous recovery in the systemically important economies of Europe, Japan, the US, and the emerging world. And it is based on durable gains in economic activity, rather than just financial engineering.

Given these features, today’s global growth spurt is starting to generate a virtuous cycle among consumption, investment, and trade. And that dynamic could pick up even more momentum, especially if the recent pro-growth measures in the US and the endogenous healing in Europe are buttressed by structural reforms, more balanced demand management, and improved international policy coordination.

In fact, the downside risks for oil prices have shifted from the demand side to the supply side.

Higher oil prices tend to erode production discipline in OPEC, particularly by members (such as Nigeria and Venezuela) that have historically rushed to secure higher revenues to mitigate difficult budgetary conditions, at the expense of their peers (such as Saudi Arabia and the United Arab Emirates). This tendency makes coordination with non-OPEC producers more difficult. Add to that the increased production from alternative sources (most consequentially, shale) that higher prices encouraged, and the beneficial demand effects are offset, if not overwhelmed.

Yet, with some minor modifications to the current agreement, OPEC members should be able to maintain their collective production discipline, assuming the will is there. They may find it harder to continue to rein in non-OPEC countries. But, with thoughtful negotiations that incorporate insights from game theory, this, too, is possible.

When it comes to the factors over which oil producers have less control, the outlook is less hopeful. The depreciation of the US dollar – which fell 10%, in trade-weighted terms, in 2017 – has helped to drive up oil prices, but it is likely to be halted and then partly reversed. Avoiding that outcome would require Europe and Japan to continue to outperform market expectations, both overall and, more important, relative to the US. Moreover, the European Central Bank and the Bank of Japan would need to tighten monetary policy – including accelerating the taper of their large-scale asset purchases – faster than markets expect.

Finally, there is the challenge posed by increased shale production. And the fact is that there is little the traditional oil producers can do to counter shale producers’ likely response to higher prices.

Given this, oil producers would be well advised to treat recent oil-price gains as a temporary windfall, not a permanent state of affairs or even – unless there is a notable geopolitical shock – a trend that is likely to intensify in the year ahead. This means that producers should resist the temptation to use their higher revenues for new recurrent spending. And they should act quickly to reinforce their collective discipline to minimize the risk of a free-for-all that negates the hard-earned gains of recent years.

Mohamed A. El-Erian, Chief Economic Adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-Chief Investment Officer, was Chairman of US President Barack Obama’s Global Development Council. He previously served as CEO of the Harvard Management Company and Deputy Director at the International Monetary Fund. He was named one of Foreign Policy’s Top 100 Global Thinkers in 2009, 2010, 2011, and 2012. He is the author, most recently, of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.

Goldman caught between calm markets and a stormy White House

If the picture is reversed it will help Wall St but could prove unsettling for Main St

William Cohan

Martin Chavez, Goldman’s chief financial officer, said that three of the group’s four business segments had logged ‘stellar’ performances © Bloomberg

One of the great ironies of the moment — unlikely to last much longer — is that we find ourselves living through a time in which a most volatile, unpredictable and seemingly unstable US president is presiding over some of the most quiescent capital markets ever.

Instead of Donald Trump’s juvenile and needlessly provocative tweets about the relative size of his “nuclear button” sending stock markets reeling in fear of a thermonuclear showdown with Kim Jong Un, they are continuing to hit all-time highs. On Wednesday the S&P 500 Index crossed 2,800 for the first time, up 34 per cent since Mr Trump’s election.

Instead of long-term interest rates rising in reaction to the president’s new tax law that is predicted to add $1.5tn to the $21tn national debt over the next 10 years, they have remained at nearly historical lows, despite five Federal Reserve interest-rate increases in the past two years. Where there should be volatility, there is calm. Where there should be fear, there is greed. What gives?

Take the curious case of Goldman Sachs, long viewed as one of the savviest risk managers and profit makers on the planet. It should have been able to make money hand over fist in the past year, given the soaring markets, its dominant and nearly unassailable position as the longtime world leader in providing bespoke advice on mergers and acquisitions and its historical prowess in securities trading, both for its clients and its own account. Instead, the media is filled with stories wondering if the mighty Goldman has somehow lost its magical touch.

Make no mistake, Goldman still had a fine year: at $32.1bn net revenue was 5 per cent higher than in 2016; net income of $8.7bn was up 17 per cent. Nearly $12bn will be paid out in compensation and benefits to its roughly 36,600 employees. Its stock has been trading at or near its all-time high. Martin Chavez, Goldman’s chief financial officer, said in announcing the company’s latest earnings that three of the group’s four business segments had logged “stellar” performances.

Yet there is much hand-wringing both inside and outside the bank about its seeming inability to make money in its core fixed-income, currency and commodity operations — FICC in the Goldman lexicon. Once upon a time this was an extraordinary revenue and profit machine; now it has fallen on harder times. FICC revenue in 2017 was 30 per cent below the previous year; in the past quarter it was down 50 per cent from the fourth quarter of 2016. Mr Chavez said that one-third of the decline in FICC revenue last year was attributable to the commodities’ business’ “inventory challenges” and “muted client activities”.

Mr Chavez made his name at Goldman in commodities, and is highly attuned to its problems and its opportunities, as are the other top executives. Lloyd Blankfein, the bank’s longtime chief executive; Harvey Schwartz, co-president and co-chief operating officer; and Gary Cohn, its former president and now Mr Trump’s chief economic adviser, all started at J. Aron, the commodity business Goldman bought in 1981.

A big source of Goldman’s woes is coming from markets being way calmer than anyone could have predicted after a year of living with a high-beta US president. The commodity business “begins and ends with clients”, Mr Chavez said. “The clients want to buy, we sell; they want to sell, we buy. It’s intermediating all along the value chain from producers to refiners to consumers in all kinds of different product formats, which could be physical, futures, systematic trading strategies, derivatives.” The problem has been, according to Mr Chavez, that too many of Goldman’s FICC clients have not wanted to buy or to sell.

Despite the pessimistic headlines about its 2017 performance (“Weak Results for Goldman Show Depth of its Fall” was the New York Times take), there is no need to fret about Goldman’s future. It will be just fine, as it mostly has been for the past 149 years. It has benefited — and will continue to benefit — from a growing worldwide economy, from cheap money, from a lower corporate tax rate, from fewer genuine competitors since the financial crisis, and from its ability to innovate and to hire and the best and brightest people. Unlike its few remaining peers, it has made huge investments in technology. Some 30 per cent of its employees are engineers. It has an unparalleled line-up of future leaders and has connections to powerful people nearly everywhere.

And market volatility will soon increase, that’s for sure. The new tax law has already forced many of Goldman’s best clients — corporate executives, hedge funds managers and private-equity moguls — into scrambling to figure out how best to grapple with its many changes. They look to Goldman for advice and new trading strategies.

The bigger concern is for the rest of us. Volatility may be good for a Wall Street trading desk, but it is more than a little unsettling for Main Street. Unless and until Mr Trump curtails his bombast, which is unlikely, his unpredictability, his inconsistency and his inarticulacy pose a threat to world peace and to world markets, which will inevitably fall the moment fear replaces greed as investors’ main emotion. We have been more than a little lucky with Mr Trump so far. I fear it may soon be running out.

The writer, a former Wall Street investment banker, is the author of ‘Money and Power: How Goldman Sachs Came to Rule the World’

What Should the Fed Do When No One Listens?

The Federal Reserve is tightening but financial conditions are getting looser. For the central bank, that presents a problema

By Justin Lahart

The Federal Reserve Bank of Chicago´s financial condition index

Note: Values below zero indicates conditions are looser than average

Investors are ignoring the Federal Reserve. That could make the Fed’s job more complicated.

Fed policy makers concluded their first meeting on the year Wednesday, and while they kept rates on hold, they also provided an upbeat outlook on the economy that made clear that they expect to raise rates at their next meeting in March.

The Fed raised its target range on overnight rates three times last year, and projects it will raise rates another three times this year. But the Fed’s moves don’t seem to be putting up much of a headwind. Stocks are richly valued, and corporate bond yields are extremely low versus comparable Treasurys. On Wednesday, the Federal Reserve Bank of Chicago reported that its financial-conditions index has dropped to its easiest level since 1993.

With newly enacted tax cuts pumping fresh funds into the economy, and President Donald Trump on Tuesday calling for a $1.5 trillion infrastructure plan, financial conditions may get easier. That goes against the Fed’s goal of making them tighter.

For the Fed, the situation is both unsettling and familiar. When the central bank raised its overnight target rate from 1% in mid-2004 to 5.25% in mid-2006, financial conditions remained remarkably easy. There were plenty of reasons why, including money gushing into the U.S. from overseas, aggressive lending practices and mistaken beliefs about the risks inherent in many financial products.

The Federal Reserve raised its target range on overnight rates three times last year, and projects it will raise rates another three times this year Photo: Andrew Harrer/Bloomberg News        

But the Fed also played a role. Not only was it slow to start raising rates following the mild 2001 recession, but when it did start raising them it did so exactly a quarter point at each meeting.

Investors felt they knew precisely where rates would be at any given time, diminishing perceived risks. Asset prices—particularly those tied to housing—ran unchecked, leading to the financial crisis.

The Fed’s main concerns are jobs and inflation. Right now its rate projections are based on an expectation that unemployment won’t fall that much further and that inflation drifts up close to its 2% target by year-end.

But the Fed meets its goals by tightening or loosening financial conditions using interest rates.

If raising rates doesn’t tighten conditions sufficiently, the Fed will raise them more. And after what happened the last time the Fed raised rates but conditions stayed easy, the central bank might decide it needs to make its rate increases a little more jarring.

“Capitalism Has Failed”

by Jeff Thomas

Today, more than at any time previously, Westerners are justifying a move toward collectivist thinking with the phrase, “Capitalism has failed.”

In response to this, conservative thinkers offer a knee-jerk reaction that collectivism has also had a dismal record of performance. Neither group tends to gain any ground with the other group, but over time, the West is moving inexorably in the collectivist direction.

As I see it, liberals are putting forward what appears on the surface to be a legitimate criticism, and conservatives are countering it with the apology that, yes, capitalism is failing, but collectivism is worse.

Unfortunately, what we’re seeing here is not classical logic, as Aristotle would have endorsed, but emotionalism that ignores the principles of logic.

If we’re to follow the rules of logical discussion, we begin with the statement that capitalism has failed and, instead of treating it as a given, we examine whether the statement is correct. Only if it proves correct can we build further suppositions upon it.

Whenever I’m confronted with this now oft-stated comment, my first question to the person offering it is, “Have you ever lived in a capitalist country?” That is, “Have you ever lived in a country in which, during your lifetime, a free-market system dominated?”

Most people seem initially confused by this question, as they’re residents of either a European country or a North American country and operate under the assumption that the system in which they live is a capitalist one.

So, let’s examine that assumption.

A capitalist, or “free market,” system is one in which the prices of goods and services are determined by consumers and the open market, in which the laws and forces of supply and demand are free from any intervention by a government, price-setting monopoly, or other authority.

Today, none of the major (larger) countries in what was once referred to as the “free world” bear any resemblance to this definition. Each of these countries is rife with laws, regulations, and a plethora of regulatory bodies whose very purpose is to restrict the freedom of voluntary commerce. Every year, more laws are passed to restrict free enterprise even more.

Equally as bad is the fact that, in these same countries, large corporations have become so powerful that, by contributing equally to the campaigns of each major political party, they’re able to demand rewards following the elections, that not only guarantee them funds from the public coffers, but protect them against any possible prosecution as a result of this form of bribery.

There’s a word for this form of governance, and it’s fascism.

Many people today, if asked to describe fascism, would refer to Mussolini, black boots, and tyranny. They would state with confidence that they, themselves, do not live under fascism. But, in fact, fascism is, by definition, a state in which joint rule by business and state exists. (Mussolini himself stated that fascism would better be called corporatism, for this reason.)

In recognizing the traditional definition of fascism, there can be no doubt that fascism is the driving force behind the economies of North America and Europe.

In addition, the concept of any government taking by force from some individuals the fruits of their labour and bestowing it upon others is by no means free-market. It is a socialist concept.

And, in any country where roughly half of the population are the recipients of such largesse, that country has, unquestionably, settled deeply into a socialist condition.

However, this is by no means a new idea. As Socrates asked Adeimantus:

Do not their leaders deprive the rich of their estates and distribute them among the people; at the same time taking care to preserve the larger part for themselves?

So, which is it? Are we saying here that these countries are socialist or fascist?

Well, in truth, socialism, fascism, and, indeed, communism are all forms of collectivism. They all come under the same umbrella.

So, what we’re witnessing is liberals, rightfully criticising the evils of fascism, but failing to understand it for what it is—a form of collectivism. Conservatives, on the other hand, do their best to continue to operate under their countries’ socialist laws, regulations, and regulatory bodies, whist continuing to imagine that a remnant of capitalism remains.

And so we return to the question, “Have you ever lived in a country in which, during your lifetime, a free-market system dominated?”

Such countries do exist. It should be pointed out, however, that even they tend to move slowly toward collectivism over time. (After all, it’s in collectivism that they gain their power.)

However, some countries are “newer,” just as the US was in the early nineteenth century and, like the US, the governments have not yet had enough time to sufficiently degrade the economies that have been entrusted to them.

In addition, some citizenries are feistier than others and/or are less easy to convince that, by allowing themselves to be dominated by their governments, they’ll actually be better off.

Whatever the reasons, there are most certainly countries that are far more free-market than the countries discussed above.

But, what does this tell us of the future? What can be done to turn these great powers back to a more free-market system? Well, the bad news is that that’s unlikely in the extreme. To be sure, we, from time to time, have inspired orators, such as Nigel Farage or Ron Paul, who remind us what we “should” do to put these countries back on track, so that they serve the people of the country, rather than its leaders. But, historically, such orators have never succeeded in reversing the trend one iota.

History tells us that political leaders, in their pursuit of collectivism, never reverse the trend. They instead ride it all the way to the bottom, then bail out, if they can.

However, it is ever true that, in some locations in the world, there have always been free-market societies. Over time, they deteriorate under the hands of their leaders and, as they do, others spring up.

The choice of the reader is to look upon the world as his oyster—to assess whether he is more or less content with the country he’s in and confident that it will continue to be a good place in which to live, work, invest, and prosper, or, if not, to consider diversifying, or even moving entirely, to a more rewarding, more capitalist jurisdiction.

Refugee Reversal

Merkel's Got Some Explaining To Do

A DER SPIEGEL Editorial by Dirk Kurbjuweit

 A migrant after arriving in Malaga

German Chancellor Angela Merkel has completely reversed her refugee policies without bothering to tell German voters why she has done so. Such imperiousness is a common problem for those who have been in office for too long.

It's no longer about people, it's about a number. It's about the number of refugees who come to Germany, not about the refugees themselves. The most recent number is 223,000: That's how many asylum applications were submitted last year, a far cry from the 746,000 applications received in 2016. The new number is rather convenient for Angela Merkel in that it is extremely close to the upper limit of 220,000 that has found its way into the German chancellor's preliminary coalition outline agreed to by Merkel's conservatives and the center-left Social Democrats (SPD).

This number is the expression of a political policy that has never been clearly verbalized and never been adequately explained. It is the expression of an about-face on refugee policy, away from open borders and toward harsh rejection. Late in the summer of 2015, Merkel said that if Germany cannot show "a friendly face" in an emergency, "then it is not my county." She kept the borders open to the incoming refugees, and much of the world was inspired by her humanitarian approach.

Now, however, Germany is presenting a much less friendly face to the world. And the German chancellor has no country anymore. But that doesn't seem to be bothering her. Indeed, her views would seem to have completely changed.

In 2016, Merkel engineered a deal with Turkey on behalf of the European Union which essentially shut down the refugee route across the Aegean Sea from Turkey to Greece. She also agreed to demands from the conservative Christian Social Union (CSU), the Bavarian sister party to her own Christian Democrats (CDU), that an annual upper limit be established, though it isn't allowed to be called an "upper limit." In the future, there is also to be a 1,000-per-month upper limit applied to family reunifications for most refugees. That is too low.

The CDU and CSU are fond of emphasizing family values, yet they have joined forces to limit family reunification -- even though it should be clear to everyone that men have the best chances at integration if they live here together with their families. But none of that matters anymore. The parties only care that the number is low. And SPD leaders are going along without complaint. That, too, is a disappointment.

It is, of course, impossible for the country to take in 750,000 asylum-seekers year after year without overburdening German society. But why was the CSU allowed to determine the upper limit? Why has the German chancellor opted for silence on this issue? There was once a time when she was considered the climate chancellor, before quietly turning away from climate policies that had already been agreed upon. Because they were no longer politically convenient.

Merkel's Fear of Losing Power

That's her style -- and it has been an impertinence for quite some time. Liberal democracy, after all, is primarily characterized by the fact that people talk to each other. And this time around, it's not just an impertinence. It shows serious contempt for many German citizens.

It wasn't just politicians who sustained the refugee policies pursued by the country in 2015. Many, many German citizens rolled up their sleeves as well. They helped the state, which wasn't well prepared at all, they welcomed the arriving refugees, supporting them and sometimes even bringing them into their own homes. They contributed actively, and many continue doing so today by helping refugees integrate into this society. They are the the friendly face of Germany.

These citizens must now stand by and watch as Merkel, out of fear of losing power, is pushing the policies of the others. The policies of those who are less welcoming, those who are potential supporters of the populist Alternative for Germany (AfD) party, those who want as few asylum-seekers coming to Germany as possible.

Merkel is currently building the country they would like to see and is pursuing policies consistent with their view of the situation. Of course, there were and still are enormous problems with the refugees. But there is also a hysterical view of the situation that has little to do with reality. The sexual assaults that took place in Cologne on new year's eve 2015 were horrifying, but the years since have shown that it is possible to get such problems under control. Every rape is one too many, but reporting by DER SPIEGEL has shown that there is a significant amount of inaccurate information on the issue being disseminated in an attempt to defame refugees.

Liberal elements of society expect an open debate. Merkel should long ago have held a speech explaining at length why she so dramatically changed course. Had she done so, some might have understood her arguments and opted to support her new policy. Others would at least have been able to say: The chancellor is taking us seriously. And perhaps the debate following the speech would have produced a different number. For the moment, though, it's hard not to feel insulted by this ludicrous tiptoeing around the term "upper limit." It's like kindergarten.

The refusal to engage in an important discussion is characteristic of monarchies, not democracies. Simply ignoring previous promises reveals a rather imperious bearing -- the arrogance of power. It is something that is almost unavoidable to those who have been in office for too long.