Deficiencies in the E.U. Capital Markets: A Silver Lining

With the IMF reducing its forecast of E.U.[1] economic growth for 2015 by 0.2% to 1.2 percent, E.C.B. officials still intent to go ahead with the much-anticipated “quantitative easing” program (i.e., buying state bonds), and, the euro having recently fallen 12% against the U.S. dollar since peaking, and crude oil prices below $60 a barrel in January, the limited scale of the E.U.’s capital markets relative to their American counterparts exacerbated the E.U.’s blight. Most directly, the lack of diversification on the types of capital markets meant that the focus on the bonds issued by state governments would continue.[2] With an upcoming election in the state of Greece making stock markets jittery due to the risk that the state might default on its bonds, the precarious condition of a relatively undiversified capital market added, albeit subtly, to the sense of risk in the air. Having had years to develop alternative markets since the financial crisis, E.U. policy makers had no one to blame but themselves—it would seem. However, a bright spot in European culture or society may be responsible for the lack of development.

The size of the corporate bond market was at the time just 34% of the American counterpart as a proportion of GDP, according to New Financial, a think tank in London.[3] The E.U.’s leveraged loan and securitization markets were 19% and 17% the size of their U.S. counterparts, and the venture capital market was just 15 percent, again all in terms relative to GDP.[4] Because the respective U.S. counterparts dwarf the E.U. markets by such an amazing extent in terms of GDP, part of the explanation may involve different business cultures with respect to debt.

With the U.S. federal debt at nearly $18 trillion and the previous year still showing a deficit of over $400 billion, and almost a third of student loans in default, it is easy to view Europeans as relatively debt-averse even if the post-financial-crisis years of debt-weary states (i.e, the “PIGS”) present an image to the contrary. I suspect that the relative skepticism on debt is in turn a manifestation of European society being less infatuated with business and thus less reflective of its culture. Put another way, the positive connotation that leverage (i.e., using borrowing in productive investment to hopefully capture more of the returns than is possible in the case of stock-issuance capital financing) has in the business world has been more salient in American society than in its European counterpart. Considering the misuse of debt-financing in the American and European housing markets that led to the financial crisis in 2008, the relative size of the European capital markets as of 2015 has a silver lining.

---

[1] Specifically, for the part of the E.U. that uses the euro currency.

[2] Simon Nixon, “A Continent in Need of Greater Capital Markets,” The Wall Street Journal, January 20, 2015.

[3] Ibid.

[4] Ibid.

Oil Supply: Problem or Panacea?

Between June 2014 and January 14, 2015, crude oil prices fell by 57 percent. Between November 1985 and March 1986, the prices had fallen by 67 percent.[1] That time, it took nearly two decades for oil prices to rebound. Would it take that long again? The answer has implications for how efficient the market mechanism itself is, and in turn for public policy on energy and global warming.

According to The Wall Street Journal, the discovery of oil in shale rock makes all the difference. The difficult question involves what that difference might be. With less time entailed from discovery to extraction, and less cost relative to the more traditional sources such as off-shore oil, the supply of oil on the market should be able to adjust downward much quicker, resulting in higher crude prices, other things equal. For example, wildcatters in Texas discovered the Eagle Ford Shale in 2008; within only five years, a million barrels a day were going to market.[2] “Faster-reacting shale production could help cut supply more quickly than in the past, restoring market balance without a decadeslong wait.”[3] This assumes the efficient market hypothesis—that suppliers quickly reduce their respective contributions to the market as a result of lower prices.

So it is surprising that the Journal cautions that the faster-reacting shale production does not necessarily “mean prices will rebound soon, or return to the triple-digit levels . . . Price pressure may need to remain on the U.S. oil industry and its lenders for months to rein in supply.”[4] Andrew Hall, who runs a $3 billion energy derivatives hedge fund, wrote to investors that it is unclear how long it would take for American suppliers to cut back due to the lower prices and even what the new price-equilibrium would be.[5]

For one thing, oil producers sunk into contracts would rather get as much revenue as they can, even if they will still lose money. Although shale producers have a shorter timeframe, the short life of a given well means that the producers are under pressure to start new wells in order to cover as much of the initial investment as possible. Put another way, keeping production up is the better of two bad options.

With the tap expected to remain open, the supply of oil from shale was predicted to peak in 2020, after which the annual decrease in oil from liquid sources would be less and less made up by oil from shale. By 2030, the production from liquid sources could be only half of its level in 2014, with no oil left from shale. In short, the lack of a drastic downturn in supply during the last half of 2014 suggests that the American economy might suffer shocks in the 2020s as oil prices skyrocket from dramatically reduced supplies. With alternative energy representing only about 3% of the total in 2014, even increased investment in wind and solar facilities would not counter the anticipated drop in oil supplies.

Had the oil market in 2014 been more in keeping with the efficient market hypothesis—with supplies dropping drastically as the prices of crude drop likewise until the reduced supply pushes the prices back, up at least partially—the anticipated “cliff” in the early 2020s could be either flatter or delayed. Policy makers would have more time to get the economic “up to steam” on alternative sources of energy. Already in 2014, when I was driving across the Midwest, I was stunned by the number (and size) of “wind fields.” Even so, considering that carbon emissions were at the time going in the wrong direction—up instead of down—the continued supply of oil in spite of the lower prices must have been relieving pressure on policy makers to reduce the reliance on fossil fuels. Meanwhile, the lower gas prices gave American consumers the misperception that oil supplies are just fine and a lack of incentive to obviate global warming above the 2C degree threshold.

In short, the lack of an efficient market was forestalling vital public policies concerning both the American economy and climate change. It is not that an efficient market would obviate government action. In fact, just the opposite.

---

[1] Russell Gold, “Back to the Future? Oil Replays 1980s,” The Wall Street Journal, January 14, 2015.

[2] Ibid.

[3] Ibid.

[4] Ibid.

[5] Ibid.