The nasty repercussions of a shifting energy market

The unintended consequences of ultra-loose monetary policies are being felt in commodity and financial markets, and hint at more turbulent times ahead.

The collapse in the oil price may be just one of a number of symptoms of the changing global economic and financial landscape, but it is having profound consequences.

It was always going to be a delicate, dangerous and uncertain process to unwind the consequences, intended and unintended, of the unconventional responses to the global financial crisis six years ago, given the scale and novelty of the actions taken and the capital flows they encouraged.

With some elements of that process underway and accelerating as the US economy and monetary policies edge towards more normal settings and China still grappling with attempts to rebalance its faltering economy, however, the destabilising impacts of the reversal of the capital flows that US quantitative easing and China’s own response to the GFC promoted are becoming increasingly evident.

With the US Federal Reserve Board meeting tonight for the last time in 2014, another potential flashpoint in an already emerging crisis is approaching. Any sign that US rates will begin rising ahead of market expectations could exacerbate some of the destabilising trends already occurring.

The oil price collapse reflects to some degree the reversal of the two great policy responses to the original crisis: the $US3.5 trillion US experiment with quantitative easing and China’s own stimulus packages in 2008 and 2009, estimated at close to 6 per cent of its GDP.

The property-based investment boom that generated in China sucked in the cheap capital exiting the US, turbo-charging its growth, and had flow-on effects throughout developing economies and commodity-supplying economies like Australia, which benefitted from the associated boom in their terms of trade.

Over-laying the real economic activity were vast speculative financial plays in commodities and currencies, fuelled by the unconventional monetary policies adopted by the EU, the eurozone and Japan and the incentive near-zero interest rates created to chase risk.

As the US economy recovered and China’s slowed in response from its authorities to the various speculative bubbles that had emerged within an immature economy and financial system, there were always going to be some significant repercussions.

The wildcard that has emerged as the US has inched towards normalisation of its settings, however, has been the shale oil and gas boom in the US which is rapidly shifting the status of the US from the world’s biggest energy importer towards self-sufficiency.

That fundamental structural change to the world’s energy markets that has really only emerged over the past few years is over-laying the post-crisis developments in economies and financial markets. To some extent, it has exaggerated the pro-cyclicality to some of those developments.

There are both financial market and geo-political implications from that rapid change to the energy markets. The most visible has been the turmoil that a near-halving of oil prices is now generating within Russia, with the rouble in free-fall and Russia’s central bank forced into a dramatic but so far futile monetary policy response.

The impact of the role reversals of the US and China economies, with the US now steadily strengthening and China slowing, was already having an exaggerated effect on commodity prices. This is because the combination of China’s demand and the 'financialisation' of commodities had a leveraged effect on both supply and prices during the period when China underwrote the commodity boom.

Most commodity markets, including oil, are now heavily over-supplied at a time of weakening demand and the financial flows are reversing. The US shale gas revolution has exacerbated the impact on energy markets and probably magnified that reversal of capital flows.

Capital is now pouring out of the developing world and back into the US driven by a combination of influences.

There’s a flight to safety occurring and a compounding currency effect as the US dollar strengthens that is producing, at least for the moment, a perverse outcome. Even as investors ponder the timing of the rise in US official interest rates, the financial flows are forcing US Treasuries yields down.

A stronger US economy and dollar, a weaker China and lower oil prices may not be good news for developing economies, which face currency and capital flows-inspired increases in their debt and interest obligations, and may be pushing Russia into perilous economic and financial territory.

Low energy prices are generally regarded as positive for the developed economies and the prospects for their economic growth rates. They also, however, can generate geo-political instability and tensions and have to be seen in the larger context now developing.

The oil price might be good for eurozone businesses and consumers, for instance, but the strengthening of the US dollar and its impact on capital flows and the pricing of capital is threatening to a still-overleveraged region. Instability within Russia is also, obviously, disturbing for Europe.

The more stable parts of the Middle East have been dependent on oil revenues for their stability and development. An oil price below $US60 a barrel generates significant pressure on their finances and potentially their stability, while the rapid shift towards energy self-sufficiency in the US undermines the global strategic relevance they have had in the post-war period.

The global policy settings since 2008 have been designed to try to create a pathway to economic recovery for the US and the eurozone, despite the continuing fragility and vulnerability of the financial systems under-pinning the global economy. In more recent times China, too, has been trying to promote more stable fundamentals within its economy.

Given the untested nature of the strategies central banks and governments have pursued since the crisis, however, there were always likely to be unintended and potentially nasty repercussions as they -- particularly the US and China -- tried to unwind some of those measures and normalise their settings.

It would appear that, as the punctuation point for the US post-crisis episode of unconventional monetary policies draws inexorably closer and China’s spluttering attempts to shift to more sustainable settings continue, some of those repercussions might be emerging.