OPEC’s Move Was To Stop The Economic Time Bomb

By Bryan Rich 

November 30, 2016, 3:25pm EST

Over the past year we’ve talked a lot about the oil price bust and the threat it represented to the global economy.  And in past months, we’ve talked about the approaching OPEC meeting, where they had telegraphed a production cut – the first in eight years.  Still, not many were buying it.

Remember, it was OPEC created the oil price crash that started in November of 2014 when the Saudis refused a production cut.  Ultimately the price of oil fell to $26 a barrel (this past February).

Their strategy:  Kill off the emerging threat of the U.S. shale industry by forcing prices well below where they could produce profitably.  To an extent it worked.  More than 100 small oil related companies in the U.S. filed for bankruptcy over the past two years.

But it soon became evident that cheap oil threatened, not just the U.S. shale industry (which also turned out to threaten the global financial system and global economy), but it threatened the solvency of OPEC member countries (the proverbial shot in the foot).

The big fish, the Saudis, have lost significant revenue from the self-induced oil price plunge, starting the clock on an economic time bomb. They derive about 80% of their revenue from oil.  With that, they’ve run up their budget deficit to more than 15% of GDP in the oil bust environment.  For context, Greece, the well known walking dead member of the euro zone was running a budget deficit of 15% at worst levels back in 2009.

So OPEC members need (have to have) higher oil prices.  Time is working against them. With that, they followed through with a cut today.  Remember, back in the 80s when OPEC merely hinted at a production cut, oil jumped 50% in 24 hours.  Today it was up as much as 10% on the news. But this cut should put a floor under oil in the mid $40s, and lead to $60-$70 oil next year.

All of this said, given the increase in supply from bringing Iran production back online, and from increasing U.S. supply, no one should be cheering more for the pro-growth Trump economy to put a fire under demand than OPEC, especially Saudi Arabia.

Now, as we discussed this week, oil has been a huge drag on global inflation.  With that, the catalyst of a first OPEC cut in eight years driving oil prices higher could put the Fed and other global central banks in a very different position next year.

Consider where the world was just months ago, with downside risks reverting back to the depths of the economic crisis.  Now we have reason to believe oil could be significantly higher next year. That alone will run inflation significantly hotter (flipping the switch on the inflation outlook). Add to that, we have a pro-growth government with a trillion dollar fiscal package and tax cuts entering the mix.

As I said yesterday, we may find that the Fed will tell us in December that they are planning to move rates more like four times next year, instead of two.

The market is already telling us that the inflation switch has been flipped. Just four months ago, the 10 year yield was trading 1.32%, at new record lows.  And as of today, we have a 10-year at 2.40% — and that’s on about a 60 basis point runup since November 8th.

With that said, there has been a shot in the arm for sentiment over the past few weeks. That’s led to the bottoming in rates, bottoming in commodities and potential cheapening of valuations in stocks (given a higher growth outlook).  As a whole, that all becomes self-reinforcing for the better growth outlook story.

And that reduces a lot of threats.  But it creates a new threat: The threat of a collapse in bond prices, runaway in market interest rates.

But what could be the Fed’s best friend, to quell that threat?  Trump’s new Treasury Secretary said today that he thinks they will see companies repatriate as much as $1 trillion.  Much of that money will find a parking place in the biggest, most liquid market in the world:  The U.S. Treasury market.  That should support bonds, and keep the climb in interest rates tame.

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