Wasington, D.C. -- (ReleaseWire) -- 03/23/2015 --BENNETT: Gary Shilling is an economist who has served on the staffs of the Federal Reserve Bank in San Francisco and Bank of America. He has also served as a financial analyst and commentator for The New York Times, The Wall Street Journal and Forbes Magazine. Today he is the president of A. Gary Shilling & Co.. On February 17th, 2015, Shilling wrote an opinion piece for the Financial Post with the very startling title of "Get Ready for $10 Oil." Gary, welcome to Financial Myth Busting.
GARY SHILLING: Glad to be with you.
BENNETT: You penned a column recently for The Financial Post predicting that oil prices could continue southward, falling to as low as 10 or 20 dollars a barrel. Has anything changed since that was published to change your perspective?
SHILLING: No, not really. The rationale for that is that cartels exist to keep prices above equilibrium—OPEC is a cartel—and that encourages cheaters. In other words, somebody wants a bigger share than their allotment. So the job of the leader of the cartel—in this case, the Saudi Arabians—is to cut back its own production to accommodate the cheaters. The Saudis got a little tired to that because they cut back and somebody else grabs their market share. Those cheaters include Iran, that they are not particularly friendly with, and Russia, as they are in the opposite sides of the conflict in Syria, and they probably look on U.S. hydraulic frackers as being cheaters, they don't have hit squads out for them, but they probably do, they're taking the Saudi's share in effect. So what they decided was that they're going to play a very sophisticated game of chicken. They said 'we've got a lot of foreign exchange reserves, the other Persian Gulf sheikhdoms too; we think we can stand lower prices longer than some of these cheaters and we're going to see who chickens out.' Now you say what price does it take for somebody to throw in the towel?
SHILLING: Well it isn't the cost of meeting their budgets. The Saudi's is about 95 dollars a barrel; Venezuela, basket-case economy, maybe a 125, the same for Nigeria. No, no, and it isn't even the full cost of drilling a new well. For fracking in North America, that's somewhere between 60 and 80 dollars a barrel. But when you are in a price war, the chicken out price is the marginal cost, it's the cost of getting oil out of the ground once the wells are drilled, once the pipes are laid, and that's about 10 to 20 dollars a barrel in Texas in the Permian basin and about the same in the Persian Gulf. So that's how I get to this 10 to 20 dollar a barrel forecast and nothing has changed since I forecast that, really, starting a couple months ago.
BENNETT: As you pointed out, Saudi Arabia is behind the engineering of these lower prices, and I know that they're doing it to whittle down their competitive landscape. How long can they afford to play this game of chicken without getting economically damaged themselves?
SHILLING: Well, they've got over 400 billion dollars in foreign currency reserves and if you look at their financial needs they could probably survive on reserves alone for two or three years. As a matter of fact, the Saudi oil minister has publicly said, '40 dollars a barrel, 30 dollars a barrel, 20 dollars a barrel is irrelevant.' Now maybe a lot of that is propaganda, trying to scare off the competition, but I think they figure that they can use those reserves and outlast their competition for a while. I don't think this is going to take a matter of two years. One of the interesting things that is going on right now is that oil production worldwide is exceeding demand by a couple of million barrels a day and now that's going into storage, into land based storage tanks and into floating storage. They use ships, tankers. That storage is filling up and when they get filled up, probably somewhere around May or June, then what are they going to do? Then it's really going to be push is coming to shove, and to sell the oil then, they'll have to take a lot lower prices. As a matter of fact, it gets a little technical with the price spread between the U.S. Oil, West Texas Intermediate and Brent which is the international oil. That spread is opening, because traders are assuming that this U.S. oil surge is going to get filled up much quicker than on a global basis so it's going to be a cheaper price in this country down the road.
BENNETT: What is the implication for Main Street America? I understand there are cheaper prices for gas, which President Obama wants us to be thankful to him for, but then he warns us not to buy gas guzzlers as the price will eventually go up. Is there an investment play you're seeing here?
SHILLING: Well of course the auto companies have benefited because people are buying the SUVs and the pickups in the U.S., so, they switched over there. That goes back and forth with gas prices, like night and day. It benefits consumers in general but—this all happened on November 27th when Americans are sitting down to their Thanksgiving turkeys and that's when OPEC made this decision. People thought instantly that there was going to be a big surge of spending in December because people would spend the money they're saving on gasoline. Guess what? Retail sales went down in December, they went down in January, they were down for February. They've gone down three months in a row. People aren't spending that money that they save by paying less for gasoline and other energy. They're saving it, and usually they do save initially. If you look back at the tax cuts and tax rebates in reaction to the Great Recession, people initially save, they spend some of it later, they adjusted their budgets. But for three months they're not spending it. They are actually saving it. They are cutting back on their total retail spending. I think it's telling you something. Of course, if you'll look at those with babies for example, they have a desperate need to save. They've been lousy savers and they are going to either save like they do in Singapore where they save half of their after tax income, or they're going to work till they die. That's pretty much the choice for a lot of folks who have babies.
BENNETT: I think there's an even bigger economic story than oil in 2015, which is debt, both governmental and corporate. It seems like the U.S. dollar is going to continue to rise more or less in spite of itself.
SHILLING: I think you're right and you have two sides of this oil effect. One is the benefits for consumers. For the U.S.--we're still a net energy importer, and of course Western Europe, most of Asia, those places obviously get a break with lower energy cost. But then you look at the oil producers and the service companies and the countries like Russia and Venezuela that depend almost exclusively on oil exports to fund their governments and their imports, and they are in big trouble. One of the things that tells me is that there's a tremendous amount of financial leverage out there among energy producers and related companies, in the speed with which they cut back their current and capital spending after the OPEC decision. They didn't even wait for the dust to settle, they cut back immediately. What that had told me was that not all the money that the Fed and the other central banks have been pumping out went into stocks, some of it went into energy and that's put them in a very, very leveraged position so that they really can't stand the effects of price declines for a very long.
BENNETT: What about the global credit market? Some of money obviously went there, especially in the emerging markets. It was all based on cheap and available dollars and since the aura of growth was temporary and illusory, in my opinion, I would think corporate and government debt may not fare well. Are we heading into a major reset?
SHILLING: Well, we very well could be. I mean if you go back 20 years, they call them petrol dollars, they were circulated around and basically covered the financial needs of the developing countries and I think we have a similar situation today. In the late 90's, during the Asian financial crisis, they owed a tremendous amount in foreign denominated debt, and their currencies were linked to the dollar, and that was a real mess. They are not quite as exposed as then, but there is exposure there, and we ought to say that if you look at the currencies of particularly countries like Russia, Brazil, their currencies are really taking a nose dive and it's because money is fleeing. People worry about it and they say, 'Wait a minute, this is a shaky situation.'
BENNETT: Speaking of emerging markets, you've written that growth in China is slowing. What's your forecast? Some are calling for a big correction, while others are insisting that China is just stumbling a little bit in what is otherwise an upward trajectory. Where is China headed and how will a weaker China affect the U.S.?
SHILLING: Well, China was growing about double digit rates up until the Great Recession. They took a nose dive; they put out a lot of stimulus through bank loans, recovered; they got a lot of real estate speculation that authorities didn't like; they got inflation bubbles they didn't like, so they have been clamping down. They are moving to a slower growth. They say their target now is no longer double digits, it's 7 percent real GDP growth for this year. But everybody knows they lie about the numbers. I would say the real growth there is probably no more than 4 or 5 percent and it's headed lower. It's headed lower because China's gotten to the point where they are getting the underemployed and unemployed people working. They don't have that pool of labor to put to work. Also, they've absorbed enough a lot of western technology. It's easy to grow when you're using somebody else's technology but when you've got to develop your own, it's just going to be one of the problems. So I think China's gotten to the point where they are headed for slower growth. And then they've got a number of factors there that are pushing growth slower.
They are trying to convert from an export led, infrastructure spending led economy to more services and consumer spending. That transition is difficult and there will probably be slower growth for lavish result. They are also trying to deal with corruption. President Xi is out to get some of his non-friends, shall we say, and also clean up corruption. And you'd say, 'Well that's a good thing, let's get rid of the bad guys,' but a lot of those bad guys are the guys who run the economy—the government, the party people and the state-owned enterprise head—and they're really keeping their heads down, they are really scared so it has a negative effect on the economy. They've got the shadow banks which the government doesn't like. They're control freaks, they don't like this lending outside of their direct control.
There's a lot of factors of it and China's going to slow down. Now you say what are the effects? Well China is a big exporter, they are exporting a lot more than they are importing. They import raw materials and it does effect raw material producers. We're seeing that in the collapse in commodity prices, and that was going on long before energy went off the cliff. They export goods and of course the U.S. has benefited from cheap Chinese exports. We get their exports, we give them dollars and then they use those dollars to go out and buy and pave what they call the Silk Road and really try to expand their influence throughout Asia.
So, there's no free lunch on that deal but the direct impact of slowing growth in China, I think, is more probably in the political and military arena than it is in trade, as far as the U.S. is concerned. Now for some of the exporters of commodities, countries like Brazil and Australia, boy, that's a different story, because they really depended on China to take iron ore, copper, coal, all these things they produce and export.
BENNETT: What about the U.S. dollar? According to Reuters, China has set up an international payment system that's going to allow them to process cross border yuan (Chinese currency) transactions and they going to start in early September and October of this year. Do you think this is going to accelerate the demise of the dollar's status as an international currency?
SHILLING: No, not at all. We've done a lot of work on that over the years and we've looked at what it takes to be the world's reserve currency, going back to ancient Roman times. There are a number of factors. You have to have a large economy. OK, China has that, the U.S. has that. It has to be an economy with productivity growth: U.S. has that, China is slowing down. But you have other things. You have to have open and free markets and no restraints on currencies. China is not in that league and they are unlikely to be for a long time. They want to control that concern. They want their lunch and to eat it too. They want to have an international reserve currency but they want to control it and that doesn't work. Money around the world goes to where the markets are free, it doesn't go to where they are controlled, and it's unpredictable because you don't know what the governments going to do. So yeah, they are trying to get more influence from the currency, they just want to be a bigger fish in the world pond, but I don't think it's going to make much difference.
Right now, 88 percent of all the world's transactions involving a foreign currency is through dollars.
BENNETT: What if they standardize the yuan, back it with even a small amount of gold?
SHILLING: I don't know if it will make much difference except for those who are really concerned about gold, and that isn't a huge number. You know that the Swiss just had a referendum where they wanted 15 percent of the Swiss National Bank's assets to be in gold and that was voted down by the Swiss electorate in the referendum. If anybody loves gold, it's the Swiss.
BENNETT: I want to follow up on that, because you wrote a piece on copper and how, contrary to expectations, many commodity prices are falling. Commodities are often seen as a hedge against fiat currency and those paper currencies, especially in the developed economies, are heading into rough territory because of debt and the sheer amount of money that's being printed. What is the conventional wisdom missing here?
SHILLING: Well, it's missing a fact that all this liquidity is not turning into stimulation of goods and services. Keynes, in the 1930s, talked about the liquidity trap—pushing on a string is the analogy. The Fed, central banks, if you pull on the string you get results, so they try pushing on the string. If it doesn't happen, it collapses. Tremendous liquidity has been created but I wrote a book in 2010 called The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. We're in this, we're working down the excess financial leverage built up in the 1980's and the 1990's and what that has done, that deleveraging, has simply swamped all the fiscal signals that we're seeing around the world including all this excess liquidity that's been build up by central banks. The result is slow growth, and we've probably got at least three or four more years of that if the history is any guide. So, this liquidity is just kind of sitting there fallow. When we resume rapid growth, hey that's a different story. But for now, it's just a book keeping entry.
BENNETT: How are we going to resume rapid growth? The slow growth is materializing just like you expected. We have getting pockets of deflation, we have pockets of inflation, especially when you go to the grocery store. Our listeners can tell you that flour, for instance is up 200, 300 percent in the last four or five years. Maybe oil is going down, but we have these pockets of inflation-deflation. Do you think the Feds are succeeding?
SHILLING: Prices never move the same, but if you look at the overall situation now in the U.S. with the consumer prices, in January, we're down versus a year ago. If you look at the 34 countries covered by the OECD, the Organization for Economic Cooperation Development which includes the 34 largest economies in the world, 19 of them have consumer prices that have declined year over year. What's interesting is if you strip out food and energy, which are volatile and of course a lot of deflation has been in energy. If you do that in the last month, month over month, 17 of those countries have seen declines in prices, without food and energy. Of course, it's always easy to remember the prices they go up, that's the devil personified. When prices go down, it's because I'm a great bargainer, I'm a great shopper.
BENNETT: Well to that point, do you think we have another tech bubble? The NASDAQ has just broached 5,000. Is this a good reflection of the values of the companies?
SHILLING: There certainly is a lot of speculation going on there and you look at what's happened to venture capital and private equity moving into this area and the IPO's and the pricing and so on. I'm wondering with Apple—and Apple has been obviously a hugely successful company—what I'm wondering is with the new smart watch, have they gone a bridge too far and is that going to prove that they went over the top because they're pricing that as a luxury item and a lot of people in this country just can't afford one.
BENNETT: That's right.
SHILLING: Purchasing power is down from where it was 10 years ago. So, we'll see how that goes but that may be overreach. Still, it's hard to bet against Apple. But I think there has been a tremendous rush into tech and it's an area where somebody with the bright idea can literally develop something in the garage that then they take to a couple of rounds of venture financing, and go public and now the guy's a billionaire in a few years. You don't have to set up a factory, you don't have to hire a lot of people, it's the easy route up, but it's an easy route down as well.
BENNETT: So the tech bubble is back?
SHILLING: It may be, it may be. You're never sure until these things break. It's not as obvious as dot.com bubble in the late 1990's to be sure, but I think there have been excesses there.
BENNETT: Gary thank you so much. That was Gary Shilling, president of A. Gary Shilling & Co.
All data sourced through Bloomberg
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About Dawn Bennett
Dawn Bennett is CEO and Founder of Bennett Group Financial Services. She hosts a national radio program called Financial Myth Busting http://www.financialmythbusting.com
She discusses educational topics and events in the financial news, along with her thoughts on the economy, financial markets, investments, and more with her live guests, who have included rock legend Ted Nugent, as well as Steve Forbes and Grover Norquist. Listeners can call 855-884-DAWN a as well as take podcasts on the road and forums for interaction.
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