The Uselessness Premium

SUBHEAD: Without four more Saudi Arabias ready to dump fuel on the market the price is set to rise. By Steve Ludlum on 2 March 2011 in Economic Undertow - (http://economic-undertow.blogspot.com/2011/03/other-shoes-and-uselessness-premium.html) Image above: Egyptians hold shoes in the air in defiance of dictator Hosni Mubarek a month ago. From (http://photoblog.msnbc.msn.com/_news/2011/02/01/5969373-protesting-egyptians-hold-shoes-aloft-an-insult-in-arab-culture). Shoes have been in the news a lot lately. People have been bombarding unpopular officials from China to Libya with footwear. Heaving shoes at someone is an insult in the Middle East. Right now, in the West, everyone is waiting for our own next shoe to drop. When this shoe appears the world is going to be heading for the hills! Tomorrow? How about next week? Will it take $140 oil to cause the sham-recovery to fall off the rails? What happens next? With oil priced near $120 per barrel (Brent) it's only a matter of time. Within a few months, all else being equal, something important -- systemic -- will break. It's hard to say what it will be. It could be an Irish or Greek default. Japan could have a jump in interest rates. A China bank could fail as its real estate lending bubble pops. Saudi Arabia's 'excess capacity' could be exposed as the charade it really is. Junk bonds and munis look like bed-wetters as well. Meredith Whitney got into hot water with the CNBC crowd by pointing out the obvious: US municipalities are broke! Once pilloried: now vindicated! Comes Nouriel "Dr. Doom" Roubini saying much the same thing. States and locals are underwater for trillions due for operating expenses, retirements, capital spending on expensive sprawl and fees to Wall Street to manage the resulting ongoing mess. A large muni default or a bankruptcy such as Los Angeles or Miami could be that falling shoe. Who in Washington is willing to bail out Blue State California? Don't look to Obama. He's busy remaking himself into Wall Street's New Best Friend. The other shoes to drop could be a five-million man/woman March on Washington bound and determined to 'Clean House'. Some shoes. Some drop! Yet another could be a government shut- down leading to a 'technical' default. What is a technical default, you ask? It's the same damned thing as a regular 'Brand X' default where you are unable to service your obligations. Could this happen as a direct consequence of high oil prices? The answer depends on how you connect the dots. A little law and order would torpedo the fraud-based stock market. What would happen if the Fed's little money laundering operation was exposed to public inspection? What exactly IS on the Fed's balance sheet and who did they 'buy' it from and under what terms? What about the sagging real estate markets in the US and elsewhere? Popping the housing credit bubble was the catalyst of the Great Recession and there are new bubbles in Australia, Canada and of course, China. The US housing and commercial real estate markets have been taking it in the neck since 2007. The entire US market is a house of cards requiring endless bailouts. What happens when the next bail isn't forthcoming? Both default and accountability are outcomes of severe economic stress. High oil prices put pressure on credit markets. Some kind of money-like substance has to be scrounged up to keep the wonderful pet cars running in circles. If the cash is lacking the need is for credit to fill the gap. Right now new credit is being used to push the price of crude and other resources higher. It's hard to say how much credit is available to the economy in addition to that being used by said economy to defeat the itself. Enough credit to push the crude price higher leaves not enough for the end users. This is an amplification of the dynamic in place since 1999 when crude prices doubled from $12 per barrel. Credit-driven oil prices ration demand by limiting access to credit. Finance can gin up as much credit as it needs for speculation purposes. Finance refuses to do the same for purchasers who would willingly borrow but cannot earn enough from using (wasting) the fuel to service the resulting loans. This grand economic theory is called 'Painted Into A Corner-ism', where blossoming demand, credit saturation and market speculation undermines itself. The modern world is insolvent due to the massive overhang of unserviceable debt. High fuel prices increase the amount of debt that must be repaid without gaining any increase in productivity! There is more to pay with diminishing means to do so. Instead of restructuring and writing off debts and conserving energy the Establishment promotes more waste and adds more debt. This is madness! Our phantom recovery is dependent upon $100 billion per month being recycled by the Fed and Treasury then pumped as 'new money' into finance. Enron-style crooked accounting supports all the major banks and insurance companies in the US and elsewhere. High oil prices create competition for credit. When it becomes a bit more expensive liquidity vanishes taking with it the reassuring platitudes of the Establishment which are exposed as flat-out lies. Confidence evaporates and the runs out of 'securities' begin. While the Fed can technically support its bankrupt clients with guarantees and interest- free loans it cannot do so in the required amounts with a straight face. The Fed needed to float $13 trillion in guarantees and loans to bail its clients in 2008. How much would the Fed need to float in 2011? $26 trillion? $40 trillion? Any promise of support at this level would be absurd on its face. I can write a check for $26 trillion that is just as good as Bernanke's. What's the point? $40 trillion might not be enough. Nobody knows what is on finance world's balance sheet. Not just the Fed's but all the banks, non-banks and shadow banks. What's with the hedge funds? That the large institutions are 'stable' is an assumption. Banks and others have massive derivatives exposures with imperfect hedges. The large portfolios of mortgages loans and derivatives are proving to be unsecured. The maturities of securities held by the establishment as collateral are out of whack. The Estimable Mike Shedlock points out the banks are returning to the fatal practice of lending large amounts at low rates: 'borrowing short and lending long'. Short rates cannot be guaranteed to remain low forever. Furthermore, short rates are just as vulnerable to fuel price pressure as the longer variety despite ongoing Fed's open market operations. Both the Fed and the Treasury are borrowing short and lending long. This may not trigger a deleveraging but certainly is a vulnerability. What happens if the Fed is unable to defend current near-zero short rates? The issue of government borrowing orbits around its offering a better return that the private market can. If price pressures demand more credit, this assumption fails. Instead of lending funds into existence, the powers-that-be rent risk into existence. When risk emerges from the Treasury-Fed combo the ability of the Establishment to issue meaningful guarantees vanishes. The Fed may have the mechanical ability to add more liquidity but doing so would be counterproductive. At that point there is for all practical purposes no more Fed, no lender of last resort. To paraphrase Frederick the Great: 'He who seeks to guarantee everything guarantees nothing'. The great unraveling illuminates the central truth about Peak Oil. The black goo has intrinsic value, finance and its embedded institutional stupidity does not! Central banks with ballooning balance sheets and worthless assets do not fall into any value category. Once people snap out of the dream-state of magical thinking and sense the Establishments' true worthlessness the finance game is over. Since the giant banks are less vulnerable in a practical sense, they will not fall first. The place to look for stress is in the money markets and markets for commercial paper. Anyone needing a quick liquidity fix will go to these markets. Establishment guarantees to these markets will not produce the desired outcome but will amplify the force of the runs instead. I don't have to make this up. This process is already underway in Ireland. Government guarantees to banks with massive credit overhangs have bankrupted the Irish state. In a post-peak oil world we are all Leprechauns, now. It is hard to tell in advance when an action will have the desired result or, instead, causes a fatal reaction. When overnight lending rates bolt -- which they will -- then the giant banks' rottenness will manifest itself in the form of margin calls and the large-scale unloading of collateral assets for whatever bid can be had. It will all come out of the blue! 'Nobody' will have seen this coming. Good grief! Six months ago oil prices were expensive but a tolerable <$80 per barrel. This chart is the front month Brent Crude futures contract from TFC Charts:

See that long vertical line at the right side of the chart? That's the consequence of Libya's revolution- in- progress. It may take months or even years for that production to be put back on line. Qaddafi shows no inclination to abdicate and his opponents are too weak to force him out militarily. Even if Qaddafi bows out, there is little in the way of a centralizing establishment in Libya to bring order and set the oil infrastructure to work. Creating fuel production in a failed-state Libya is beyond the grasp of the EU's and United States' unconventional 'assets'. Blatant military intervention would be opposed by Russia, China and no doubt the other oil-producing autocracies. Starting in September of last year, Brent prices took off like a rocket. Some blamed QE and money-printing but the real culprit was and is the lack of any investment opportunities in the 'fuel user' category. We humans already have all the car-manufacturing capacity we will ever need. We also have surplus capacity in tract houses, shopping centers, box office buildings and in the finance needed to create more. Some wags suggest we need more roads to put the excess cars on but this is a fool's errand as we also have a surplus capacity of roads, seeing as how the most heavily used are such only twice a day. Since none of the above are particular 'money makers' the alternative is to buy and hold -- or simply keep in the ground -- the crude oil itself. The same wags that demand more roads are also at a loss as to why those with crude don't simply dump what they have on the market and drive prices lower. What the wags don't understand is that the holding is also a form of capital investment. The competition for capital is between the saturated fuel use market and the ballooning 'uselessness' value of the crude in hand. This is a hard market to grasp! How does one value uselessness and how can this 'non-thing' be sold? The best way to look at uselessness value is to consider it analogous to 'Reserves'. When analysts suggest higher oil prices magically bring more reserves to markets, the uselessness value of oil keeps what is 'discovered' in these same reserves from ever reaching the markets! Oil only has value in that minuscule space between its removal from the ground to the instant it is converted into work. Oil that is in the ground and off the market is useless. That uselessness becomes more valuable the longer the oil is held off the market. The short road might be rendered longer by something like policy or accident. Oil might simply be ignored or it might be destroyed without anything 'useful' being done with it as was the case in the Gulf of Mexico last summer. While no producer nor user would willingly allow this to happen, those trading in fuel acknowledge this course of events as a convincing likelihood. Holders of crude play chicken with hapless users. They 'hold' the economies of the fuel-dependent world hostage by 'holding' a match to their own assets. All that is necessary is for producers to keep fuel under their control and away from the markets. In the 'non-market' the 'non-thing' gains value and a lot of it. That this hostage taking works can be seen in prices that are going up while new fuel disappears from the marketplaces. This is not supposed to happen. Conventional economics insists that higher prices are self-liquidating! The cure for $10 corn is $10 corn. High prices for corn -- or anything else -- will bring more farmers to plant corn, with more corn on the markets driving the price lower. Oil at a $100 a barrel is supposed to do the same! In the post-peak oil world we are now in, oil is now worth more than the work that can be done with it. Like real estate, work is underwater. The more oil is needed to do some bit of work, the more underwater it is. Since work is underwater the investment needed to improve work's productivity is instead directed toward the 'useless' holding of oil. The spread between what work is worth and what oil can gain on a speculator's market is the 'Uselessness Premium'. Peak oil indicates insufficient oil flows to satisfy burgeoning demand. Producers look at the trends. They see the price rising by the week and sensibly hold their oil and wait for the higher price, collecting their uselessness premium. Saudi Arabia proclaims a spare capacity and a willingness to put this on the market. Such spare capacity is not reflected in the price which climbs relentlessly higher. Meanwhile, the price bolt leaves the economic actors in a jam. To pay the higher prices they have to borrow more. The outcome is an increased demand for credit at any price. Guess what, credit costs are bolting along with the fuel prices with one acting to amplify the other in a vicious cycle. Meanwhile, the higher credit costs are ricocheting through the rest of the economy. Mortgage rates are up a percentage point since late summer as are Treasury bond rates. Euro-denominated lending rates are higher still along with rates in China and Japan. The direct cost for the world's 80 million barrel per day liquid fuel waste habit is $8 billion. Since July the increase amounts to a 30% rise in price which falls most heavily on the marginal fuel and credit users. A $2 billion rise in price per day since the summer is almost $14 billion per week which has to be extracted from a level of business activity which hasn't grown an additional 30% revenues or returns! The $14 billion per week comes out of the hides of working people and small businesses. The effects ripple up and down the economic food chain. Last year saw more personal bankruptcies. Unlike large businesses which reorganize or liquidate, small businesses don't bother to file and simply close their doors. Contrary to what the 'wags' suggest, oil prices are shocking the economy toward recession right this minute. Pump prices are a factor. The average US gas price according to Gas Buddy is $3.38 per gallon. $4 is a few weeks away. This is bitter medicine for an economy built around $1 gas. Without four more Saudi Arabias ready to dump fuel on the market the price is set to rise. Oil costs appear bound to test the 2008 high of $147 per barrel. With markets driven by momentum and the scramble for credit, the inevitable crash may take place AFTER the Brent price broaches that level and establishes a long-term bull market in crude. OUCH! The inevitable crash, the other shoe waiting to drop. See also: Ea O Ka Aina: Waiting For the Other Shoe to Drop 12/27/10