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Benton D Struckcheon

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Member since: Fri Jan 18, 2013, 09:06 PM
Number of posts: 2,347

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Why the Fed Doesn't Matter: Blame the "Roving Cavaliers of Credit"

The name, in full, of the Fed is the Federal Reserve Bank of the United States. What does that mean? It's in the name: it was conceived as the reserve to which the banks would resort when they were experiencing a run.
In its first big test, the Great Depression, the Fed failed miserably. So badly did they fail that a new agency, the Reconstruction Finance Corporation, or RFC, was brought into existence under Hoover. It tried, but also came up short.
Finally, under FDR, a couple of legislators, Representative Steagall of Alabama, and Senator Vandenberg of Michigan, inserted into the Glass-Steagall Act the creation of the Federal Deposit Insurance Corporation.
The contrast in success between the Federal Reserve and the FDIC is summed up in these two quotes from John Kenneth Galbraith's Money: Whence it Came, Where it Went:

1. On the Federal Reserve:

In the twenty years before the founding of the System there were 1748 bank suspensions; in the twenty years after it ended the unstable anarchy of private banking, there were 15,502.

2. On the FDIC:

In all American monetary history no legislative action brought such a change as this…In 1933, 4004 banks failed or were found unfit to reopen after the bank holiday. In 1934, failures fell to 62, only nine of which were insured. Eleven years later, in 1945, failures in all of the United States were down to one.

Roosevelt merged the RFC into the FDIC, which continued to exist right through WWII.

To give it some credit, Bernanke did make some attempts at staving off a huge bank run in 2008, but once again came up short. Lehman, the instigator of that year's run, was neither a member of the Federal Reserve nor insured by the FDIC. Given 75 plus years to figure out how to get completely around the system meant to tie them down, the nation's financiers had, finally, succeeded. But 75 years is quite a long time to go between huge banking crises, and it took a partial repeal of Glass-Steagall (the parts that separated investment and commercial banking) PLUS the repeal of the Bank Holding Company Act of 1956 that prohibited interstate banking PLUS the repeal of usury laws, allowing unlimited profits to be made in finance, PLUS a truly monumental amount of ingenuity fueled by the hiring of hordes of rocket scientists deploying arcane formulas to hide the risk of the speculation they engaged in, to succeed in finally giving us a crisis worthy of standing up to a comparison to the one that started the Great Depression. That's how well the FDIC succeeded in stopping banking crises.

So, if the Fed can't stop bank runs in a truly big crisis, still, doesn't it control the money supply and therefore the rate of inflation and even employment?
The idea that it does is based on the notion that the money supply can be controlled from a central source. The idea is that by controlling the reserves that a bank has to keep against outstanding loans you can restrict or expand credit. In this theory, a certain amount of money - called "base money" - would be created first by a central authority like the Fed. The banks put this in their reserves, and lend against it. Receiving, say, a million simoleons, they'd lend ten million, given a reserve requirement of 10%. If the system worked this way, you should see base money, aka the monetary base, expand first, and then credit expand afterwards. But as Aussie economist Steve Keen pointed out in Feb 2009, in a truly great essay on his blog titled The Roving Cavaliers of Credit (a quote from Marx) back when the crisis was still in full swing, the evidence directly contradicts the theory:

...rather than credit money being cre­ated with a lag after gov­ern­ment money, the data shows that credit money is cre­ated first, up to a year before there are changes in base money. This con­tra­dicts the money mul­ti­plier model of how credit and debt are cre­ated: rather than fiat money being needed to “seed” the credit cre­ation process, credit is cre­ated first and then after that, base money changes.

The essay goes into great detail, and if you're interested in this stuff, it's an excellent read. But the point of why this is so can be made very simply: if banking is a business, and its primary source of profit is the making of loans at a rate of interest that exceeds what it pays on deposits, then it will make as many loans as it can regardless of any reserve requirement and figure out how to get the money to report a good reserve requirement afterwards.
In real life, this is exactly what happens. Here in the US, banks are required to report the average level of their reserves once every two weeks, on Fed Wednesday, as it's called in the business. Note that: the average level of reserves. It's done this way because trying to minutely keep track of your reserves minute by minute is just unrealistic, even in this modern age of computing. As long as you only have to report an average, the reserve level can dip and rise as needed in the intervening period, firstly, and secondly, given that time lag, you can always get the money you need from other banks via the interbank lending market, which is the market that the Fed Funds rate is used for.
As Keen points out, the Fed and the other rich world central banks long ago gave up trying to regulate reserves in any sort of strict way, because they realized how unrealistic it was.

As for interest rates, the only rate the Fed directly controls is the Discount Rate. This is the rate at which member banks are made to borrow from the Federal Reserve. This is a ridiculously unimportant rate in normal times, because in normal times banks only get money from the Fed if they absolutely have to to cover their overnight cash needs. No one does it regularly, and it's always considered a big deal if you do, because it shows you haven't managed your money properly.
Banks get their money if they need it from the interbank market previously mentioned, the one where the Fed Funds rate is used as a benchmark. But the Fed doesn't directly control that one. It sets a "target", but that target is regularly missed in both directions.
Here's the graph of the target rate of Fed Funds:

…and the effective rate of Fed Funds, as in what the market rate actually was:

The effective shows more variation, but seems to follow the target rate.
But what if it's the other way around? What if the effective rate leads the target, rather than following it? Remember, the rate is set by traders in the interbank money market and at what rate they will actually lend to each other. If the Fed sets and enforces the target, rates should move towards the target after the Fed announces the target. But if rates are already moving in the direction the Fed was going to move the target to before it actually did, then it's reasonable to say that the Fed is following the market rather than leading it, and doesn't exert any meaningful control over it.
I tested this by taking the difference in the effective rate versus the average rate for the 21 days (there are on average 21 working days in a month) preceding a change in the target. Out of 150 instances, in 108 of those cases, the market was already moving in the direction the Fed moved the target rate. In other words, if the target was going to go up, the effective rate was already rising, and vice versa.
So, we have only two rates that the Fed has any real control over. Over its own rate for lending out money, the discount rate, it has absolute control, but that rate is rarely important. Over the only other rate it allegedly controls, it follows rather than leads moves in that market. Rather than the Fed setting the rate, the sequence in the overwhelming majority of the cases (108 out of 150, or 72% of the time) is that the market sets the rate, and the Fed follows it with an official announcement.

So, let's recap:

1 - The Fed was founded as the reserve of last resort for banks experiencing a run. It failed that test miserably first time it was really tested, and hasn't done much better since.
2 - Its reserve-setting function doesn't actually do anything. The Fed has admitted as much by relaxing the reserve requirement it allegedly enforces to such an extent it's basically irrelevant.
3 - In interest rates, it does control its own rate for lending out money, but that rate is mostly unused. The other rate it allegedly controls, it apparently doesn't, the evidence rather strongly suggests.

So, I like Janet Yellen. I'm sure she'll be useful as far as taking to the bully pulpit to get economic policy moving in the right direction. But for the reasons noted above, the Fed is mostly useless. It could - and in my opinion should - be merged into the FDIC, as the FDIC long ago proved better at its one truly vital function: stopping bank runs.
Posted by Benton D Struckcheon | Thu Nov 14, 2013, 09:35 PM (0 replies)

Five Year Anniversary of Sept 15: What Actually Happened

It'll be five years since the crisis really began this coming Sunday, the fifteenth. The below is my personal opinion, which I held in real time as it was happening five years ago, on what the causes were.
Or, actually, the singular cause: the total screwup of the bailout of Fannie and Freddie, specifically, the failure to bailout the preferred shares of these two.
What follows is a series of links with commentary that are the timeline, as I see it, of what caused the crises. Posting it here in the Economy group because I don't think the knowledge required to understand the below would be general.


In the first part of 2008, the government sold preferred shares of Fannie and Freddie to banks around the country. This was a way of putting more equity into these two, and therefore providing them with more reserves against losses in their mortgage portfolios.
As the summer of 2008 wore on, it became obvious that the two would need an outright bailout. What began to be debated was the structure of that bailout.

John Dizard of the Financial Times on the preferred shares of Fannie and Freddie, August 31, 2008:

In the now overcrowded world of investing in distressed securities, the standard strategy is to pick the “pivot” issue...In the past couple of weeks it seemed that the entire US economy had a pivot security, or set of securities: the preferred stock issued by the government-sponsored entities, or GSEs. Fannie and Freddie, the Sodom and Gomorrah of “public/private partnerships”, sold about $36bn (£20bn, €24bn) of non-cumulative preferreds to the banks and the public, with the aggressive support and encouragement of the US Treasury and the GSEs regulator...The banking system needs to raise several hundred billion dollars of equity, and preferred stock is the lowest-cost way to do that in the public markets. While some sophisticated investors could distinguish between preferreds issued by a sound bank holding company, and preferreds issued by the overleveraged F&F, international investors and domestic retail investors would not have the data or analytics to draw the distinction.
The alternative, as I see it, to recapping the US banking system with preferreds is some form of direct government investing in the equity of banks or bank holding companies. That would be even more expensive to the taxpayers – as in at least 10 times more expensive.
As a reality check I called Jim Grant, of Grant’s Interest Rate Observer, and the author of the forthcoming “Mr Market Miscalculates”. He comments: “The alternative to preserving the value of the GSE preferreds? Prayer? Remember that a lot of that paper is held by the same banks the authorities would love not to fail.”

So, on August 31, John Dizard of the Financial Times and Jim Grant, a very well known Wall Street bond market guru and editor of his own (very expensive) Grant's Interest Rate Observer is of the opinion that if the preferred shares of Fannie and Freddie aren't bailed out - as in their dividends being continued - it would cost ten times their market value of 36 billion dollars, or 360 billion dollars, to the taxpayer for the subsequent bailouts of failed banks. At least.

Fannie and Freddie Bailout

Hank Paulson did not share Dizard's opinion. Apparently, he opted for prayer. The below is from the statement issued on Sept 7, 2008, detailing the terms of the bailout of Fannie and Freddie:

Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses. The federal banking agencies are assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.

The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below "well capitalized." The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations. Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly.

The fallout from their failure to bailout the preferred shareholders of Fannie and Freddie was immediate. Despite the date you see now, this story is on events that happened on Sept 8, the day after the above statement:

Fannie, Freddie Takeover Jolts Preferred Stock Market

Sept. 10 (Bloomberg) -- Treasury Secretary Henry Paulson's takeover of Fannie Mae and Freddie Mac is roiling the market for preferred securities.

Prices of fixed-rate preferred stock fell an average of 11 cents to 69.8 cents on the dollar this week, including the biggest one-day drop in a decade on Sept. 8, according to Merrill Lynch & Co. index data. The 13 percent decline compares with a 0.8 percent drop in the Standard & Poor's 500 index in the same time.

In putting Fannie and Freddie in conservatorship, Paulson scrapped dividends on the mortgage-finance companies' equity securities and said the U.S. would buy as much as $200 billion of preferred stock ranking ahead of existing issues. Investors are more hesitant to invest in similar securities of other financial institutions on concern that Paulson set a precedent for issuers. Unlike common stock, preferreds typically carry fixed dividends.

Paulson's ``actions have damaged the preferred market,'' said Thomas Hayden, the investment strategist for Liberty Bankers Life Insurance in Dallas. ``Somebody is going to be looking at an issue of Fannie or Freddie preferred shares that were rated AA up until a few months ago. If that's not money good then what about the small regional bank in some part of the country?''

Hayden, whose $1.5 billion fixed-income portfolio contains preferred shares of Fannie and Freddie, said he's ``not interested'' in buying any more preferred securities.

Rising Costs

The market's tumble is making it more expensive for banks and brokers trying to raise fresh capital after taking $506 billion of writedowns and losses on the collapse of the subprime-mortgage market.

Dizard on Paulson's trashing of the preferreds:

“When they get in trouble, they send for the sons of bitches.”
Admiral Ernest King, on being appointed commander of the US Fleet by President Roosevelt after Pearl Harbour.

In the Bush Administration, when they get in trouble, they send for the hacks and yes-men. Ernest King did not go along to get along. He did not think his job was to make other members of the nation’s leadership feel good about themselves; he was, as he said, a SOB. On the other hand, Roosevelt wanted somebody who knew how to win the war in the Pacific, and that’s what he got.
Hank “The Plank” Paulson, US Treasury secretary, now has his place in history, but it’s not one the rest of us should envy. He will be in the book on the same page as his counterparts in the latter days of the French Third Republic. The Admiral Kings, or the people who organised the rescue of New York City in the 1970s, will be on different pages.
I wrote that the alternative to saving the value of the preferred would be direct Federal capital support for the banking system, and that this would be 10 times as expensive.
One financial commentator thought that I had a point, but that the 10 times estimate was“snatched from thin air.” Actually, no. To get the banking system back to something close to balance sheet health will require capital raises in the order of $400bn. The preferred stock value that disappeared with Mr. Paulson’s “rescue” was around $36bn. There you are.
Now, if Mr Paulson and his team had an alternative plan that made sense, some creation of structured finance magic that would leave us gasping at the genius of it all, that would be different. But no.
In his statement on the Fannie and Freddie actions, he said: “Preferred stock investors should recognise that GSEs [government-sponsored enterprises]are unlike any other financial institutions, and consequently GSE preferred stocks are not a good proxy for financial institution stock more broadly ... the broader market for preferred stock issuance should continue to remain available for well-capitalised institutions.”
Not true, Mr Paulson. The market for bank preferred stock is effectively closed. It is not immediately obvious now how the banks can raise the Tier One capital they need to finance a recovery ... scratch that, not a recovery, just the present level of economic activity.

Lehman Downgraded, then Bankrupted

Lehman had already been known to be in bad shape. They were one of the banks looking to go out and issue new shares to recapitalize themselves. But of course now the preferred share market was closed off; no one was going to buy new preferred shares in any bank after what had just happened to Fannie and Freddie. On Sept 9, Fitch downgraded Lehman. The link is gone now, but Fitch's reason for the downgrade was the difficulty Lehman would have raising new capital now that the preferred share market had been hit.
The downward spiral of Lehman's stock really took off after this downgrade. The next weekend the Fed and the usual suspects gathered again, as they had in March for Bear Stearns, to see if they could find a way to rescue Lehman. No way was found.
The events of the Lehman weekend, during which BOA decided to buy Merrill instead:

NEW YORK — Transforming the face of Wall Street, two major securities firms succumbed Sunday to the country's long-running mortgage crisis as Merrill Lynch & Co. agreed to a hastily arranged, $50-billion takeover by Bank of America Corp. and Lehman Bros. Holdings Inc. spiraled into bankruptcy...The crumbling of Lehman and buyout of Merrill came only one week after the government committed up to $200 billion to shore up home-loan giants Fannie Mae and Freddie Mac.

The run begins: money market fund breaks buck, freezes redemptions:

Primary Fund , managed by New York-based money market fund inventor The Reserve, said late Tuesday that its $785 million holding of Lehman Brothers Holdings debt has been valued at zero.

As of 4 p.m., Eastern, the value of the fund's share was 97 cents. The Reserve said that redemption requests received before 3 p.m. will be paid out at $1 a share. The company said Primary Fund will continue to accept new money.

While Primary Fund's Lehman holding was small compared to the fund's overall size, the fact that it froze redemptions reflects a surge in redemption requests by investors.

The size and speed of the withdrawals was stunning. At 3 p.m. on Tuesday, Primary Fund's assets stood at $23 billion, a $40 billion hit from the $62.6 billion in the fund on Friday, a spokeswoman for The Reserve told MarketWatch late Tuesday.

The Crisis

After this, the Fed backed up all money market funds, Paulson went to Congress for the TARP, AIG went belly up, and on and on.
But the sequence of falling dominoes began with Paulson's failure to back up the 36 billion dollars of preferred shares issued by Fannie and Freddie. Dizard's original estimate of 360 billion for the cost of that mistake was, as it turned out, low: the TARP cost a trillion in up front money. There are varying estimates of how much the government has received back from that money, but the entire bloody mess could have been avoided by simply continuing to pay the dividends on those preferred shares, thereby keeping the market for banks' preferred shares open, which would have allowed Lehman and Merrill to muddle along the way Citi eventually did (it issued tons of new stock as a result of the TARP, diluting its existing stock by 90%, but it survived) and avoided the subsequent collapse of the money market.

But they chose not to, opting instead, apparently, for prayer. And so it went.

Posted by Benton D Struckcheon | Fri Sep 13, 2013, 07:44 PM (4 replies)

Brazil Looms Larger

The US views Latin America as its backyard. Brazil is beginning to feel the same way about South America, where it is the biggest and richest country...
The anti-imperialism of the most progressive among Brazil’s senior civil servants is like Pomar’s. He thinks that, irrespective of the political convictions of its backers, a movement founded on this anti-US rhetoric could spur social change: “Every attempt to build a socialist bloc in Latin America has run into two obstacles: the power of the Latin American bourgeoisie, and that of the White House. Brazil’s integration initiative will not eliminate outside interference, but will reduce its impact, and give national politics greater autonomy.” The tough stance of the Union of South American Nations (Unasur) — founded in 2008 — probably helped to foil Bolivian and Ecuadorian coups in 2008 and 2010. When the Venezuelan opposition and the US challenged the validity of the election of Nicolas Maduro, Unasur supported Hugo Chávez’s designated heir. “In the past, issues of that kind were settled by the Organisation of American States — that means by the White House,” said Pinheiro Guimarães. Secretary of State John Kerry recently referred to Latin America as the “backyard” of the US (4)...
South American countries are rich because of natural resources (of which they are now in a position to regain control), but are struggling to diversify their economies and build up their means of production. During the recent presidential election campaign in Venezuela, Maduro complained: “Our country does not have a real national bourgeoisie ... the sectors involved in economic activity are highly dependent on American capital.” (Rentier behaviour is the norm.) He appealed to anyone who could help Venezuela to “lay the foundations of a productive economy” (5) — a message addressed to the “nationalist private sector” but which he may hope will reach Brazil, where industrialists are supposed to be more progressive...
In April, Pinheiro Guimarães gave an example of regional solidarity: “Under the Lula government, something extraordinary happened: a subsidy from Brazil made it possible to start building a transmission line between the hydroelectric plant at Itaipu and Asunción” (11), ending the power cuts in Paraguay’s capital. The business leaders of São Paulo drew other conclusions: “Labour-intensive sectors in Brazil, such as the textile and garment industry, would improve their competitiveness relative to their Asian competitors on Brazil’s domestic market if they were to offshore part of their production operations to Paraguay,” where “wage costs are around 35% lower” (12).

Source: Le Monde Diplomatique
Posted by Benton D Struckcheon | Thu May 30, 2013, 08:59 PM (16 replies)

Venezuela's Bigger Problem

Actually, it's a problem for other countries as well: Chile comes to mind, for instance. The problem? Overdependence on commodity exports.
A lot of pixels get burned out in this place talking about internal stuff re Venezuela, and I've been guilty right along with everyone else around here. But whether Chavez was corrupt or Capriles deserves to be impeached for not attending to his duties as governor is for the people of Venezuela (or Capriles' province) to decide.
Some things, however, can be addressed objectively. One of these is that if the election of Maduro was reasonably clean, say, Obama should recognize it, regardless of being called a devil or any other name by Maduro.
Another of these is that Venezuela is entirely dependent on oil for its export earnings. As I said, it shares this overdependence on raw materials earnings with a lot of other countries. And to be crystal clear so this doesn't get involved in just the issue of Chavez, it predated his rule as a problem for Venezuela and there is no evidence that I can find that his opposition understands the problem either.
Which isn't surprising, as I don't think it's appreciated just how bad this is as a problem.
The reasons it's bad, and particularly so for Venezuela, are as follows:

1 - "The Resource Curse": this is a well-known drawback to economies like Venezuela. The basic idea here is pretty simple: dependence on a single commodity distorts both the politics and economics of a place, since everything revolves around the resource in question. Venezuela has this big time, as the major focus of the government's political and economic energy is PDVSA, and the distribution of its earnings. Who controls PDVSA controls Venezuela. This makes politics a zero-sum, binary game. This usually means you don't get republican government (see, for instance, Saudi Arabia or any of the other Middle Eastern states for the most part), but despite coup attempts by Chavez in '92 and his opponents at least twice during his rule, the republic has survived for decades. How long this will last is anyone's guess, but it's not at all a given that it will last. Too much revolves around the control of that one entity and the resource it controls. 94% too much.
2 - "The Resource Curse", Part Two: The above is the part of the resource curse that usually gets written about, but there's a second problem with it: the price of raw materials isn't set by small countries with economies that are entirely dependent on that resource. They get set by the buyers: the developed economies that take those raw materials and turn them into useful products. In the case of oil, the usefulness of oil is truly amazing: it's used as fuel in many different forms (gasoline, jet fuel, heating oil, kerosene), in asphalt, which itself is used for both road paving and roof shingles, in plastics, which are used everywhere now, in synthetic fibers for clothing, to make wax in all its various forms, to make fertilizer, to make cosmetics like mineral oil, baby oil, and petroleum jelly; the list goes on and on.
Most of these products are made in developed economies rather than in the resource-dependent countries from which the oil is extracted.
Raw materials prices don't generally rise as fast as inflation. At best, like gold, they rise at the same rate as the general price level. Oil is an exception: over the long term it tends to rise at a faster pace than inflation. This is probably due to its usefulness in all of those products I just listed above. Those products were developed over time, and as each one was developed, it increased the usefulness of oil, which would of course put upward pressure on its price.
But substitution can take place in any of those products. To take two examples: in electricity generation, I have pointed out in a thread in the Environment & Energy group that oil is now used far less than wind as a fuel source. In fibers, cotton made a comeback after having been threatened by synthetic fibers. That's just two examples; go down the list of products and you can pretty easily think up substitutes for oil based products in all of them.
As oil's price rises, those substitutes become more attractive. This is what happened in electricity generation, where the per btu price of oil is now so high in relation to natural gas that it has now become a trivial fuel source in that area as utilities have switched out of oil to natural gas (while at the same time increasing their use of wind energy as well).
In short: just because oil's price has risen faster than inflation in the past doesn't mean that will happen in the future. And the threat to oil isn't just its price: it's that it is, quite literally, lethal to the planet when it's burned. At some point in the not-too-distant future the pressure to make oil obsolete as a fuel is going to become massive. For now, the fossil fuel lobbyists have been winning more than they lose, but their situation reminds me a lot of what happened with the cigarette companies, who also seemed invincible for decades. At some point something happens that changes everything, and suddenly the political hammer crashes down on the formerly invincible industry. As with cigarettes, the problem is known. And as it was with cigarettes for a long time, the evidence of lethality is building. That evidence can't be denied forever.
Venezuela is on the wrong side of this. And it has no control over the outcome. In the end, it's a small, backward economy. When push comes to shove and oil needs to be discarded as a fuel, the effect this will have on Venezuela's economy won't be anyone's concern in the developed world. It will be left behind.
Right now it's on the next-to-last rung of the international economic order: a supply region, that is, a place that produces one or a few raw materials for use by the world's developed economies. Once oil is discarded, it will be demoted to the last rung of the international economic order: it will be a bypassed place, a place that doesn't produce anything anyone else wants to buy.
Why can I categorically say that? Because, as noted above, 94% of its export earnings come from oil. As of right now Venezuela isn't selling anything else to the outside world but oil. So, what happens if because of CO2 the world rapidly moves to renewables and conservation, far more rapidly than anyone is now expecting? It would be an unmitigated disaster for Venezuela.
(Eritrea is probably the best example of a bypassed place these days.)
3 - Outsized Leverage to the Price: But let's get back to price. Venezuela has a very particular problem with the price of oil: it sells heavy crude, sludgy stuff that's hard to refine. This is a good thing in a way, since this kind of oil is ideal for being turned into a multiplicity of oil-based products, much more so than light oil. The very disadvantage of having to go through many steps to be refined into fuels of various sorts also means it can be refined into more kinds of fuels than light oil, and can be turned into more products along the way as well. But it also means the break-even price, that is, the price over the cost to refine and extract it, is also pretty high. That means Venezuela is more leveraged to the oil price than, say, Saudi Arabia, where the cost of extraction is certainly much lower, and which also produces some lighter grades of oil, which cuts the cost of refining it.
Leverage to the price means this: say crude oil sells for 90/barrel. If Saudi Arabia can produce it for a cost of 15/barrel, then a price cut from 90 to 60 cuts its income per barrel from 75 to 45. Not a good thing, but at least you're still making something decent.
But if your break-even is 40, which is more or less Venezuela's (see chart embedded in this article for the production break-even costs of various oil producers), then a cut from 90 to 60 means a drop in your profit from 50 per barrel to 20 per barrel. Or: a one third decline in the price produces a 60% decline in your net profit.
That's leverage to the price.
The problem is over the long term, the amount you get for selling any raw material is a little bit over the cost, since over the long term that's all anyone is going to be willing to pay. Venezuela's had a run of luck the past decade or so, the same run of luck as Chile when it comes to copper: China has been rapidly industrializing and therefore vacuuming up resources from all over the globe at a very rapid rate, which has supported the price of everything, even if, like Venezuela, most of what you sell goes to the US. That effect was of course magnified by its leverage to the price: a rise of 30 bucks to 120 would, after all, raise Venezuela's net profit from 50 to 80 per barrel, a 60% increase.
Point being, as a result of China's influence on the oil price Venezuela has up to now been on the good side of its leverage to the price. But that won't last forever.
4 - Politics: As the article cited above re break-even costs shows, the US is concerned, as it always is, with being too dependent on oil for its energy, and you can be sure all those tax credits going to renewable sources are in place in part to help out with that problem. Substitution via alternate sources of energy or via conservation (replacement of incandescent bulbs by CFLs and LEDs, for one example) is going to continue, and will put relentless downward pressure on the price of oil and other fossil fuels.
Particular to Venezuela is that Mexico also produces heavy grades, and as a result of the ongoing hostility between the US and Venezuela the US has a big incentive to use Mexico's oil instead of Venezuela's (http://openchannel.nbcnews.com/_news/2013/04/01/17519026-how-the-us-oil-gas-boom-could-shake-up-global-order?lite). Look for lots of deals to be signed in the next few years aimed at increasing Mexico's oil production with American help.

Chavez's rule coincided with a once-in-a-lifetime opportunity for Venezuela to make a crapload of money from its oil and use that to finance a move in its economy away from that total dependence on its price. That opportunity has been missed so far, and Maduro may not have much time left; it may be gone sooner than anyone is expecting. Even if oil isn't discarded as a fuel source (which I know seems unlikely now, but things like this have a way of changing very fast once the momentum gets going), if the shale oil boom now underway drops the global price of oil significantly, Venezuela will still suffer mightily because of its leverage to the oil price, as noted above.
The point is not that any one of these risks, political (Mexico), economic (oil price) or environmental (CO2) will materialize. The point is all of them are risks, and all are either plausible or happening right now, and should therefore be addressed by Venezuela's leadership. Chavez and now Maduro have been in power for nearly a decade and a half, more than enough time to have lowered that 94% dependence on oil for its export earnings.
Putting all your eggs in one basket is never a good idea. Inheriting that problem from your predecessors and proceeding to not only ignore it but put all your newly hatched eggs in there too is completely irresponsible. Maduro's single most important task is to start selling something to the rest of the world besides oil, in non-trivial amounts. Like, now.
Posted by Benton D Struckcheon | Wed May 29, 2013, 10:50 PM (11 replies)
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