Oil Price: A Small Boat On The Sea

The price of oil has been brought low by the collapsing global economy as we all know.  What next?  To see how far the economy may have to fall (and thus how long we can expect the oil price to be under pressure from reduced demand), let’s look at the bursting bubbles that are causing the economy to implode.  They include a bubble in housing construction and housing prices; a bubble in financing - both stocks and credit expansion; and a bubble in executive compensation.

The first two bubbles have been extensively discussed and analyzed.  Let me spend a minute on the executive compensation bubble since it rarely gets attention in the press and it has had huge impacts on the economy.  Few economic commentators recognize that one driving force for U.S. economic growth has been outsized compensation, mostly of executives, with stock options that have floated upwards in value for many years.  Stock option gains have pushed corporate compensation far higher than historical norms and I would argue, far out of line with the value of the work product of these people.

Stock options have gone from a fringe benefit for top management to a growing staple of executive compensation.  It became an annual ritual for executives to give themselves new options.  As the process evolved and as stocks rose nearly every year, executive would annually exercise the options that were profitable, sell their shares and then issue themselves new options.  So if you looked at the record of insider purchases and sales of nearly all public companies there would constantly be slews of sellers and hardly any buyers.   Who needed to buy shares of the company you work for when you are given options for free every year?

The net effect was that millions of people working for public companies have for years been pulling enormous sums of cash out of the public stocks of their companies, a cost that was never adequately reflected in the earnings of the companies or in any other way.  Many tech companies, like Google, for example, compensated virtually all their employees with options.  In such cases, literally thousands of new millionaires were manufactured in the past decade.   Perhaps such fortunes were warranted when truly world-changing companies like Google were built by hard working young people.   But the greatest amount of stock option compensation was given to executives of ordinary companies that simply benefited from rising stock prices since 1982 based in part on the the rising credit, tech, and housing bubbles.

The poster child of excessive compensation was the $400 million option compensation for Rex Tillerson, the recently retired Chairman of Exxon.  Tillerson may have run a tight ship but it is questionable whether Exxon’s strategy of sticking with oil rather than developing alternative energy has been good for stockholders long term.  In any case, Tillerson had nothing to do with the rise in oil prices that led to higher prices for Exxon shares and thereby allowed Tillerson to walk away with a king’s ransom of excessive compensation.   What makes this a bubble is that Tillerson’s compensation is mirrored many thousands, probably millions, of times - usually but not always in lesser amounts - among “executives” of thousands of public companies.

What happened to all that cash?  Some was consumed - vacations, cars, etc - and a lot of it was spent on first, second and third homes.   Those homes had a multiplier effect on other industries - furnishings, white goods, developers, brokers and lawyers, advertising, etc.  It created many sub-bubbles along with contributing to the bubble in housing prices.  Sure, housing prices rose partly due to looser lending standards.  But an important source was wildly excessive corporate compensation derived from stock options.

Now that the end of all these bubbles (housing, financing, stock option gains) has come simultaneously (because they were all related) the economy needs to fall to a level that is sustainable without such bubbles.  How much of a fall is that?  5% of GDP?  That seems easy.  10%?  Perhaps.  20%?  That seems too much.  After all, we still have perfectly viable industries that will continue operating near the peak of their output:  agriculture, education, medicine, law enforcement, food distribution, necessary housing, government, media, entertainment, transportation, technology.  Much of that output is also valued in other parts of the world economy and so enjoys export demand.

Sure, many of these industries are slowing down.   But they will not collapse like the worlds of finance, home construction, or luxury goods and services.  In other words, as we step back from the economy and look at where it needs to contract, we see that it needs to contract primarily in the areas that were propelled by the wealthy class.  Those are the folks who have been overcompensated for so many years, who have been overspending for so many years, and whose assets are in the process of contracting.

If the top 20% of U.S. economic activity generated by the wealthy needs to contract by, say, 25%, that’s only 5% of GDP.  If that trickles down to the next 40% contracting by 5%, that gives us another 2%.   And maybe we get a bit more  from the non-consumer spending part of the economy.   So it seems like an 8 - 10% decline in GDP would be more than adequate to get us to the level of a sustainable economy.

Shrinking the U.S. economy by 8 - 10% is a huge adjustment that will take a couple of years at the least to accomplish.  Right now U.S. GDP is declining at a 5% annual rate.  If we need two years of such a decline, that suggest we may start to bottom some time in 2010. That suggest that the price of oil might stay under pressure for a couple of more years in terms of demand declines.

But we don’t live in a static world.  Clearly the Obama team thinks they can shortcut the downturn by exploding federal spending.   That is going to have a catastrophic impact on the U.S. federal deficit.   Moreover, the Fed has pushed short rates to zero and longer rates to not much more.  Huge credit expansion along with wild deficit spending combined with a much weaker economy suggests that the U.S. dollar could come under great pressure at some point.

An extremely weak dollar, possibly over an extended time frame, has little precedent.  The potential impacts of that are hard to predict but it would seem likely to have a major impact on the price of oil as expressed in dollars.  Yes, there surely would still be an excessive amount of physical oil around during the next couple of years.  But the number of dollars needed to be spent by Americans to outbid those able to pay for it in the more valuable Euros or Pounds or Reminbi would make the price of oil rise rapidly in dollar terms.

So I would suggest that a potential failure of the dollar could become a wild card in the projection of future oil prices.  More important, it could be a wild card for the future of the U.S. economy.  If anyone wants to refresh her emotional concerns about this, here’s a Ron Paul expostulation on the topic.

Absent a dollar crisis, it is hard for me to see a rising price for oil over the next couple of years if it takes that long for the U.S. economy to grind its way out of the excesses of the past many years’ bubbles, not least of which has been the executive compensation bubble based on stock options.  Other economies, particularly China’s, might recover more rapidly, but it seems doubtful that the global economy as a whole, and therefore demand for oil, will begin expanding again before the U.S. economy stops contracting.   So the best near term hope for oil prices may be a falling dollar.

But a falling dollar, if sustained, could bring with it a host of other problems.  So it is not totally clear that a rising price of oil as expressed in dollars would necessarily be good for the stock market or therefore for oil stocks.  All in all, I still see no reason to own oil stocks at this time.

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