The Oil Crash

Instead of ending this blogpost with a disclaimer, I will start with one. What you will read here is my opinion and is contrary to what the majority of investors and economists believe. It doesn’t always make sense to be a contrarian investor, but at inflection points, group think can be very dangerous.

You have probably noticed it at the gas-pump; prices are down substantially. If you ask most investors what caused the price of oil to collapse, they will correctly tell you that it is due to increased supply. Stated, simply, supply is greater than demand. I agree with that. The next question would be what caused the excess supply? Most investors would then say that it was OPEC’s decision in late 2014 to keep output high. I can’t argue with that either. What that answer doesn’t address is low interest rates.

Here is what I believe caused the massive oil crash in three simple words: The Federal Reserve. How you might ask? It’s simple: Interest rates have been too low for too long and have caused the misallocation of capital across the economy. When interest rates are low, it makes buying assets using debt cheaper. If the cost of capital for the energy companies would have been more expensive, many oil projects would not have happened. In my opinion, low interest rates, coupled with technological improvement (fracking), and OPEC caused the current oversupply of oil.

I also find it intriguing that the supply / demand balance of oil proved to be fragile and the resulting price reaction was non-linear. Nassim Taleb in his book Antifragile: Things That Gain From Disorder (an excellent book by the way!), uses vehicle traffic and commute times as an example of a non-linear reaction. For example: 10% more traffic doesn’t just add 10% to your commute time; it adds much more. Increasing supply coupled with moderately less demand has cratered the price of oil.

Oil is just the latest asset to implode. Remember the housing crash of 2008 & 2009? While most people assign blame to the lax lending standards, there was also another negligent party: The Federal Reserve held interest rates too low for too long.

I also believe that low interest rates are causing the misallocation of capital elsewhere: I’ve said it before, and I will say it again, US stocks look at least fully priced, but likely overvalued. You can also say the same for housing right now. The ‘flip homes and make thousands’ commercials should be disturbing. Low interest rates make assets more valuable and central banks around the world have done their best to bring down interest rates and pump up global asset prices. In time, I believe it will be clear that low interest rates have caused misallocations of capital. If this is true, crashing oil may simply be a warning sign.

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