Behold! The Shale Oil “Deflationary Cycle” Flow Chart

Behold! The Shale Oil “Deflationary Cycle” Flow Chart

We've written exhaustively about the deflationary dynamic that grips crude markets. Indeed, what you're seeing from US producers is effectively what happens when QE and central banks inadvertently create deflation as opposed to inflation. It's very simple, really. The central bank-inspired hunt for yield drives investors down the quality ladder, creating artificial demand for HY debt and equity follow-ons. This relentless appetite for anything that offers investors some semblance of yield all
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6 thoughts on “Behold! The Shale Oil “Deflationary Cycle” Flow Chart

  1. Hello therealheisenberg,

    You wrote:”what you’re seeing from US producers is effectively what happens when QE and central banks inadvertently create deflation as opposed to inflation….The central bank-inspired hunt for yield drives investors down the quality ladder, creating artificial demand for HY debt and equity follow-ons.”

    If I understand your point correctly, you are arguing that it is the central bank of the United States, the Federal Reserve Bank (FRB), which is causing interest rates to decrease and as a result, investors have to push out into higher risk investments to find adequate return.

    I believe that you are incorrect.

    Normally, central banks seek to ease credit market conditions by lowering interest rates, an “Interest Easing Policy” (IEP). Since the overnight interest rates on bank reserves were already effectively at zero in November 2008 lowering those same interest rates was was largely pointless, IEP would not work (the “Zero Bound Problem”). QEP, increasing the *quantity* of money for leading, was hoped to provide additional *easing* to credit market, thus helping un-restrain business borrowing.

    Additionally, QEP, particularly the “Operation Twist” / “QE2” component [1], had the additional goal of lowering interest rates on longer term forms of credit. By purchasing longer term United States Treasury (UST) bonds rather than shorter term bills or notes it was believed that the credit market for longer term instruments would ease through IEP.

    QEP was also thought to be a monetary stimulus (which works through “wealth effect”) to increase aggregate demand, and to stimulate inflationary pressures to counter the intense deflationary pressures present in the economy. Certainly a very large increase in the supply of money, which occurred as a result of QEP did indeed create inflationary pressures.

    The point that you raise is how effective was QEP. As an anti-deflationary policy, it seems to have been quite effective. The velocity of money was falling significantly following the Crash of 2008 and there was evidence for the danger of falling prices. QEP was largely effective at stimulating some amount of inflation. It was below the unofficial target of 2% but it was above zero.

    However in terms of lower long term interest rates, QEP was probably not effective. While long term interest rates did indeed decline following the adoption of QEP, those same interest rates had been declining since for 30 years. The Federal Reserve Bank (FRB) itself conducted a study on this topic. They determined that the long term UST bond rates fell by 15 basis points which really not very significant [2].

    Rates of investment are not driven by interest rates. If interest rates drove investment, there ought to be an inverse / negative relationship between capital formation and interest rates. More investment ought to occur when interest rates are low and decline when interest rates are high. Generally there is a positive relationship, as businesses expand, they demand more credit[3]. If the supply of credit is stable while demand increases, then the price of credit rises, i.e. interest rates go up. It is generally a demand driven market. Interest rates do not drive investment, investment drives interest rates.

    If one examine the petroleum industry in particular, one of the few which has shown growth since 2008, there is in fact no relationship at all between interest rates and growth. Consider this graph, it shows the Value of Manufacturers’ New Orders for Durable Goods Industries: Machinery: Mining, Oil Field, and Gas Field Machinery which we can take as measure of capital formation in the petroleum industry. This is plotted against time. Also plotted is the Effective Federal Funds Rate. As can be seen, there is no correlation between the two [4].

    Investment is not driven by interest rates rather it is interest rates which are driven by investment. When businesses expand, they borrow money. As money is withdrawn from the credit market, the balance of supply to demand changes, driving up interest rates[5].

    So it is unlikely that any change in monetary policy as they impact interest rates have had little impact on investment rates investment in tight oil produciton.






    David de los Ángeles Buendía

        1. well, I mean it’s common knowledge that QE and accommodative monetary policy create a hunt for yield. It’s like asking me to explain why you’re wrong to say the sky isn’t blue. I would gently suggest that you do a little more research, because trust me, the global hunt for yield is part and parcel of the entire market narrative that has dominated for the past 9 years.

          1. Hello therealheisenberg,

            Well, I would note that the sky is not always blue, it changes colours depending upon conditions. Explaining why the sky is blue under some conditions but not others is actually not terribly simple, it requires more than bit of sophisticated thinking. I provided more than adequate evidence to support my conclusions. Can you do the same?

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