Thursday, January 15, 2009

Oil and Nominal GDP: Contango

To carry on with what the relationship of Fed Funds expected to the oil contango, and ultimately to GDP, some simple arithmetic.

First note the 10 years interest rate swap trading 10 years forward chart below. For the last 30 years nominal GDP has a close relationship to this rate.

Oil is about 8% of GDP - in various forms.

Fed Funds over time should have equivalency to (and do) to nominal GDP - it is how the Fed controls the economy via monetarism and is a well understood identity by the likes of Friedman to neo-Keynesians.

If nominal Fed Funds expect some repair from this crisis, they should trend upwards and in fact they do as the following pattern shows - extracted from swaps and not Fed Funds futures:

The Fed Fund path has to eventually connect with the 10X10 to show the evolving Fed Funds to market long term expectations for nominal GDP.

Therefore the oil contango should have some relationship to the Fed Funds expected path.

Now the math - it is clear the Fed Funds path "only" returning to 1 1/2% shows that some long running drop in nominal GDP is expected. That long running drop can be estimated by seeing the 5 1/2% nominal GDP dropping to 3%, a drop in nominal GDP of 2 1/2 % per annum. That is a drop of $350 billion per annum in nominal GDP, or say about $3.25 trillion present value. If oil is about 8% of GDP then we should have a hit of about $28 billion per annum in demand for oil from the USA and a long term present value drop of about $250 billion to $325 billion.

Longer dated oil is trading at prices reached a year ago and if the market ideas as to growth expectations in relationship to oil ("peak oil") then obviously they have not even begun to price with the market expectations for the massive changes in nominal GDP long term expectations.

Further more, the rise in Fed Funds expected is more to do with the fact the market must price at some level from ZIRP to 3% over time, but as we are seeing that is really not a discrete steps curve but a massive step function - and even a step function that is oscillating from upside down to rightside up like some demonic animated Escher print. Most feel that the Fed Fund path should be much shallower and take a much longer time to get to the 3% nominal GDP.

Finally, one has to think of the "sizzle" to "peak oil" which was the Chinese inefficient use of energy along with the their 7% to 12% growth in nominal GDP. Supposedly the isolation from the USA the Chinese miracle was establishing would keep this major effect proofing "peak oil" intact. The recent decline in Chinese nominal GDP means that somewhere in there is a path similar to our Fed Funds path in terms of change if not more so as they prove to be a leveraged position on the USA economic conditions.

Then as we hear of 80MM barrels of oil roaming the ocean in Flying Dutchman like tankers, never to find shore or the contango trade is destroyed, and as PADD II overflows, and as refiners do all they can to cause roadblocks and bottlenecks - and given the above tectonic plat shifts in macro USA expectations......

Still believe in "peak oil"? If you do I got some already filled oil tankers to sell you....

We will likely see a handle of the teens on oil before this over.

1 comment:

  1. I really like your post here and the other one you did on the money and oil curves. One caution: you'll want to make sure you are using the accepted definition of Peak Oil and not the populist, cultural definition (which is a misunderstanding). You appear to be leveraging the latter definition and regardless of one's take on oil, by using that definition you're not strengthening, but rather muddying up your argument. I say this not fully knowing whether you are, or are not, using the correct definition of Peak Oil. All I can say is that there is, however, a correct definition and it's not a demand side concept.

    Regardless, you are indeed on the right path imo in your pursuit of oil usage and GDP and the portion of oil demand and GDP, etc.