Here Is Why Those Who See In IEA's SPR Release A "Shadow QE" Are Dead Wrong

Leave it to Goldman to explain why the surge in crude prices is actually a good thing. Enter the good old ("recycled" some may say tongue in cheekly) recycled petrodollar thesis. The logic, in brief, is as follows: Petroleum exporters are the primary beneficiaries of rising oil prices and, assuming they don't use the bulk of the funds to buy their citizens' endless love (a big if in recent months), use this "savings" flow to purchase various assets from developed capital markets. To quantify, Goldman suggests that that the $70/barrel rise in crude over the past 2 years "has caused petrodollar saving flows to rise from roughly $10bn to $70bn per month, thus adding roughly $700bn of asset demand to global capital markets." Which is supremely ironic: those who claim that the IEA's action is comparable to a QE are 100% dead wrong. It is actions which raise the price of oil that have an implied QE effect, whereby the abovementioned $700 billion in recycled capital is only possible due to the surge in crude. As prices drop, whether it is due to idiotic, politically-driven actions like that by the IEA, or otherwise, the recyclability of petrodollars plunges, and far less "savings" end up being reinvested in US asset. What would be further ironic is if the administration realizes this paradox, and in order to save the market (which it will have to very soon in the absence of ongoing flow monetization by the Fed), it send the price of WTI well over $100 to generate bond buying interest in the short-term. That said, based on some of the stupidity we have recently seen out of the White House, such an outcome would not surprise us in the least.

More from Goldman:

Flow of petrodollar savings is back

Last week in our Global Economics Weekly, we revisited the global savings impact of higher oil prices and came to a conclusion that harks back to the last legs of the credit boom: Petrodollars are back (“Petrodollars redux”, Global Economics Weekly, June 29, 2011). The report estimates that petrodollar saving flows over the coming year will average $70bn/month, which exceeds the highest monthly flow of $63bn/month reached during credit boom of 2005-2007, and is exceeded only by the transitory peaks reached during the summer of 2008.

This is almost entirely a reflection of higher oil prices. Back in June of 2007, Brent crude oil was trading in the vicinity of $70/barrel, and our commodities team was forecasting $72/barrel. Based on this oil forecast, we estimated that global petrodollar savings had probably peaked at rate of around $45bn/month (“A Peak in Petrodollar Savings?” Global Economics Weekly, June 14, 2007). Petrodollar savings eventually surged to over $90bn/month in July 2008 as Brent crude oil prices soared to $140/barrel. But by March 2009, oil prices had fallen to $46/barrel, and petrodollar saving flows had collapsed to a mere $10bn/month.

Our commodities team forecasts a continued upward trajectory for oil prices. Once the market negotiates the current slowdown in the pace of economic growth, they expect Brent oil prices to rise from current levels of around $110/barrel to $114.50/barrel this year and $126.50/barrel by next summer. (They have more recently warned that the release of strategic oil reserves may cause them to adjust these levels down by $5-10/barrel, but that the upward trajectory would remain and the forecasts would still likely be above forwards.)

We focus on petrodollar flows for two reasons. First, petrodollar savings have become more important over the past decade. With emerging market oil demand growth outpacing global oil supply growth, both the level and dollar volatility of oil prices have risen substantially. The standard deviation of monthly oil price changes has increased from roughly $1.50/month during the 1990s to over $6.50/month over the past five years – a four-fold increase. In the long-standing view of our commodities research team, these changes reflect secular trends that are not likely to reverse over the foreseeable future. In our view, the long-run trajectory for oil prices is up, in which case petrodollar flows are here to stay.

Second, petrodollar savings are closely correlated with fluctuations in oil prices, so they are easy to monitor. For big oil exporting economies like Saudi Arabia, national income is heavily dependent on oil exports (in Saudi Arabia, for example, the oil sector represents roughly 50% of the gross value added). Changes in oil prices for such economies translate almost 1-for-1 into changes in export revenues. And in the short-run – before domestic demand for consumption and investment has fully responded to the increase in domestic income – the import response is small. Hence, a $1.00 increase in export revenue causes import demand to rise by roughly $0.35, which means petrodollar savings rises by roughly $0.65.

Saving rates higher, interest rates lower

The asset market implications of higher oil prices alongside higher petrodollar saving flows are bounded by two offsetting considerations. On the one hand, higher oil prices obviously represent a headwind for domestic demand in the US and Europe. Indeed, higher oil prices top our list of reasons for the recent slowing of US economic growth. On the other hand, we estimate that the $70/barrel rise in Brent crude prices over the past two years has caused petrodollar saving flows to rise from roughly $10bn to $70bn per month, thus adding roughly $700bn of asset demand to global capital markets. In a world where developed market borrowing demand is expected to remain high, this is not necessarily a bad thing.

From perspective, the slower growth and higher petro savings implied by higher oil prices are both supportive of low, long-term global interest rates. To be clear, we think these effects are well-priced at current levels. Our forecasts for 10-year Treasury remain at 3.75% for this and 4.25% for 2012, and we went tactically short the 5-year on June 28.

That said, it seems likely that just as in the pre-crisis period, greater global saving supply will disproportionately benefit fixed income. (For additional evidence along these lines, see also “The Savings Glut, the Return on Capital and the Rise in Risk Aversion,” Global Economics Paper No: 185, May 27, 2009.)

Credit market implications

For credit markets more narrowly, we have long argued that credit markets were disproportionately exposed to the push from global savings supply. This is certainly how things looked back in the fall of 2006 (see “Credit 2007: Peak or Plateau?” Credit Outlook, Dec. 12, 2006). Back then we argued the global savings were driving both easy credit and low yields, causing “increased risk appetite, easy financing for distressed firms, rapid growth of the leveraged loan market, unusually low default rates, a proliferation of leveraged, yield-enhancing credit products, and a continual compression of spreads on credit default swaps.”

As for “round two” of the surge in petrodollar savings, it is difficult to say whether the effects are likely to be greater or smaller this time. We see offsetting arguments. On the one hand, global savings flows have already begun to reallocate away from fixed income and away from the developed market economies – the US in particular. In this sense, the demand for plain vanilla credit instruments is likely to be less heated this time around. On the other hand, we strongly suspect that due to the experience of the recent crisis, financial markets in developed economies will prove highly resistant to the lure of “easy credit.” New and tighter regulatory oversight, bank capital standards, and risk management processes will all effectively work to reduce the developed market supply of credit instruments and securities available to global investors. Paradoxically, this will increase the scarcity value of plain vanilla credit products, which should push their prices higher.