Shell Abandons Arctic Oil Project, Casting Doubt on Crude Estimates in Region

Some are calling Monday's announcement by Shell Oil that it will cease drilling in the Arctic a victory for environmentalists.

In truth, it is a victory for economics. In essence, drilling in the region simply did not make financial sense.

Shell had already sunk billions of dollars into exploration, and the results were quite disappointing for the Dutch company.

Shell drilled in the Chukchi Sea this summer, but found only traces of oil and gas. The company got essentially nothing for its $7 billion exploration project.

It will result in an absolutely massive loss considering that Shell's entire net profit in the second quarter this year was $3.4 billion.

Shell’s investors must be none too happy right now. The oil giant’s share price has fallen by around a third over the past year.

When Shell got its license to explore the Chukchi Sea in 2008 and then began drilling, oil prices were more than $100 a barrel. Today, prices have tumbled to less than half that, due to excess global supplies.

The failure to find sufficient oil and gas casts doubt about the viability of future Arctic projects. That should buoy environmentalists.

But make no mistake: Shell’s decision to abandon its drilling project in the Arctic was not due to pressure from environmental groups. It was due to financial pressure.

The numbers simply didn’t add up, and economics (or good sense) prevailed.

Drilling more than a mile beneath the ocean’s surface (Shell drilled to 6,800 feet) has been compared to operating in outer space. The technology and costs involved are enormous. The process is challenging enough in the warm waters of the Gulf of Mexico. But it is another magnitude of difficulty in the frigid Arctic.

If crude prices again reach $100 per barrel, some energy companies may be emboldened to begin exploration in the area once again.

The U.S. Geological Survey estimates that American Arctic waters in the Chukchi and Beaufort seas contain 26 billion barrels or more of recoverable oil.

However, that estimate now seems highly questionable.

Additionally, an Energy Department advisory council said it would take more than a decade for oil in the Arctic to be discovered, developed and brought to market.

For example, Italian energy company Eni SpA and Norwegian producer Statoil ASA are just now moving into production on a giant oil field in the Barents Sea -- 15 years after it was discovered.

Timelines aside, it’s critical to remember that Shell didn’t decide to abandon its efforts simply because the price of oil had fallen too far for drilling to make financial sense.

Shell walked away because there simply wasn’t enough oil or gas to be found in the region, and $100 per barrel oil won’t change that.

The Debt Burden: Unsustainable State Deficits Outpacing Economic Growth

During the Great Recession, states across the country began running large budget deficits. This was to be expected. Tax receipts fell, while safety net expenditures (such as unemployment payments, food assistance and other help for those in need) increased.

While the Great Recession is defined as beginning in December 2007 and ending in June 2009, the state burdens never really went away.

Some governors cut their state’s taxes with the hope that it would increase economic activity, but unfortunately they were proven wrong.

More than six years after the alleged economic recovery began, numerous states are still running budget deficits, ranging from small states like Rhode Island to large states like Illinois.

Here are just a few examples:

• Illinois had a staggering $6 billion budget deficit in the 2014 fiscal year, and a $9 billion budget in the 2015 fiscal year — the largest state budget deficit in the nation.

• Pennsylvania dealt with a $2.3 billion budget deficit for 2015.

• Wisconsin faces a $2.2 billion budget deficit over the 2015 and 2016 fiscal years.

• Maryland grappled with a $750 million budget deficit in the last fiscal year.

• Kansas had a $710 million budget deficit for the 2014 fiscal year.

All but four states (Alabama, Michigan, New York and Texas) begin their fiscal year on July 1, meaning that they are now in fiscal 2016. Yet, the budget problems of recent years have continued unabated.

The New York Times reports the following state budget deficits for fiscal 2016, and this is only a partial list:

• Alaska is facing a deficit that could reach $4 billion in a budget of only about $5 billion — with years of deficits projected after that as well.

• Illinois is grappling with a $3 billion budget shortfall.

• Louisiana is struggling with a $1.6 billion shortfall.

• Alabama has a long-term $702 million shortfall.

• Kansas has a $400 million budget gap.

• Wisconsin has a budget shortfall of more than $280 million.

In short, the fiscal position of many states across the nation is awful, and the problem has been growing continually worse.

Just how bad is debt burden in all 50 states?

State and local governments have sharply increased borrowing over the past three decades. In 1980, they were carrying close to $400 billion in outstanding debt; by 2000, it was $1.2 trillion; and by 2013, it had reached $3 trillion, according to the Board of Governors of the Federal Reserve System.

Yet, according to another analysis, the cumulative state debt has grown much worse in recent years.

State governments faced a combined $5.1 trillion in debt, which amounted to $16,178 per capita in the nation, according to a January 2014 report by the nonprofit organization State Budget Solutions.

This means that state and local debt increased nearly 13-fold in just 33 years. Think about that for a moment; it amounts to a 1,300 percent debt increase in just over three decades. That’s astonishing!

While it’s true that state economies, revenues and budgets are also considerably larger today than in 1980, the massive increase in debt is still striking.

Given that reality, it’s not enough to simply look at the size of each state’s budget deficit; you have to consider the size of its economy, or gross domestic product (GDP), as well.

That's when the problem becomes more complicated: a whopping 47 states had deficits that were larger than their GDP growth in fiscal 2015.

In simple terms, if a state’s debt increases 2% but its economy also grows by 2%, it is effectively a wash.

But almost every state saw its debt increase well beyond its economic growth, which makes servicing those debts much more difficult.

So where is this all leading? Well, the outcomes will be very uncomfortable.

Whether it's public-employee pensions; the building, repair or maintenance of critical infrastructure; education; police; fire departments; or any of the other countless services that taxpayers have come to expect, something has to give.

The means simply do not exist to pay for all of it given the structural economic constraints.

In Here Comes The Next Crisis ’Nobody Saw Coming’, Charles Hugh Smith notes the following:

• Nominal GDP rose about 77% since 2000, while state and local debt rose 150% — double the rate of GDP. Again, debt has increased at double the rate of economic growth.

• State and local taxes have soared 75% since 2000, while earnings have risen just 38%, barely keeping pace with inflation. So, state and local taxes have risen at twice the rate of wages/salaries.

• State and local government expenditures have risen 82% since 2000 — faster than GDP, and twice the rate of inflation.

• Yet, wages and salaries are down 8.5% since 2000.

Taken as a whole, this is a recipe for disaster. All the problems from 2008 were simply papered over, not solved.

Debt is like the monster in every horror film; it’s hard to kill and keeps coming back.

This is a simple math problem, and the numbers do not add up. Debt has significantly outpaced economic growth, while taxes have significantly outpaced wages and salaries. Taxpayers are already squeezed and have little left to give.

As Herb Stein’s law states, “If something cannot go on forever, it will stop."

States cannot carry this much debt while their economies continue to struggle for growth.

This will not have a happy ending, and anyone paying attention knows this. The pending crisis won’t come out of nowhere.

It is already unfolding.

Deflation a Growing Threat

Right now, there is a growing concern about deflation around the world.

The price of oil has crashed (along with most other commodities), which has pushed down transportation costs. That, in turn, has driven down the cost of virtually all goods.

The Federal Reserve has a publicly stated goal of maintaining an annual inflation rate of 2 percent.

However, the latest inflation rate for the United States is just 0.2 percent through the 12 months ended in August.

For perspective, the inflation rate in the United States averaged 3.32 percent from 1914 until 2015.

Most worrisome, perhaps, over past year wholesale prices have fallen 0.8 percent.

Recessions are by definition deflationary, and many of the world’s major economies are now in recession -- including Japan, Russia, Canada and Brazil, for example.

Even China, the world's second biggest economy (after the U.S.), is slowing.

The Asian giant is the top user of almost all commodities, including coal, iron ore and most metals. But as its economy slows, its demand for commodities is slowing too.

China overtook the United States as the world's top importer of crude oil for the first time in April.

Though it is not in recession, China's falling demand has put downward pressure on all commodities, which is having a global impact -- especially on commodities exporters, such as Australia, Russia, Brazil, Indonesia, and the big oil producers of the Middle East.

This is adding to disinflationary pressures around the globe.

Despite their best efforts, central bankers around the world have seen inflation rates fall far short of their targets in recent years, to the point that deflation is now a genuine concern.

Central banks fear deflation above all else. When it takes hold it can be very difficult to halt, and it can be crippling.

Deflation is worrisome because falling prices make it difficult for the government and companies to repay debts. Whatever you borrow money for is soon worth less than you paid.

Delation is marked by continually declining asset prices, and is often associated with a reduction in the money supply, or credit. It leads to falling wages and layoffs, and can be the prelude to a very bad recession.

Obviously, falling wages make debt repayments more difficult (or impossible) for consumers.

While deflation is characterized by falling prices, it is ultimately a continual increase in the purchasing power of money.

While that may seem wonderful, it is a particularly troubling outcome because it de-incentivizes investment. All investments simply lose value over time, even on an annual basis. The purchase of houses, cars, commercial buildings, factories and the like quickly become bad investments.

But without these investments, the economy will spiral downward in horrifying fashion. The last time the US experienced deflation was during the Great Depression.

The specter of Japan's struggle with deflation is what worries many. The Asian nation has battled slowly falling prices for the last two decades. Despite nominal interest rates of zero, Japan is still fighting deflation.

When confronting deflation (or even low inflation), central banks will typically cut interest rates.

However, with near-zero interest rates in the US for the past seven years, there is little room left to maneuver without going into negative territory.

For perspective, the Fed's benchmark rate has averaged 6 percent since 1971, and soared as high as 20 percent in 1980.

Low interest rates generally stimulate demand, which will lift the economy. Yet, historically low rates have not stimulated demand in recent years.

Consumers remain cautious, and are wary of spending and/or borrowing at pre-recession levels.

Even though the Fed has made money very cheap and readily available, it cannot force Americans to borrow. People with huge debts, low and/or falling wages, no jobs, or the fear of becoming unemployed, will not be persuaded to borrow.

And therein lies the problem: Our entire economy is predicated on borrowing and lending for economic growth to occur.

Money is created through borrowing. Without borrowing, there is less money and no growth. Absent growth, there are no jobs. And without jobs, there is a shrunken tax base and, ultimately, recession.

The Fed is now confronting the fact that three rounds of quantitative easing (QE) and seven years of its zero-interest-rate policy (ZIRP) have failed. The Vice President of the St. Louis Federal Reserve recently admitted as much.

That’s the scary part.

When you’ve given it your best shot and it still isn’t enough, then what?

Deflation is a bitch. Just ask the Japanese.

US Economy Trapped In Long Term Decline

Call it a non-recovery.

Since the alleged economic recovery began in mid-2009, annual economic growth has hovered around 2%, well short of the nation’s historical average of 3.3%. In fact, the US economy has not surpassed 3% annual growth since 2005.

So, for a decade, the US economy has lagged its long term norm.

Yet, this slowdown is just part of a longer term decline.

From 1947 through to 2015, the United States economy grew by an average of 3.25% per year.

However, since 1973, the economy has experienced slower growth, averaging just 2.7% annually.

The best year for the US economy since 1948 came in 1950, when it expanded by 8.7%.

Here are the top five years of GDP growth since 1948:

1950: 8.7%
1951: 7.7%
1955: 7.2%
1959: 7.2%
1984: 7.2%

As you can see, four of the five best years came in the 1950s, and the other occurred 31 years ago.

Though the economy had already been in long term decline for over three decades, the growth rate has slowed quite considerably in the years since the 2008 financial crisis and subsequent Great Recession.

In response to the crisis, which nearly sank the US economy, the Federal Reserve took some rather drastic actions.

First, it lowered the Federal Funds Rate (essentially an overnight lending rate for banks) to a range of 0% to 0.25%. This has allowed banks and large corporations to borrow very cheaply for the past seven years. In fact, for the Big Banks, money has been essentially free at times.

Then the Fed started its quantitative easing (QE) program, under which it printed money to buy mortgage bonds and Treasuries. In fact, the Fed ultimately unleashed three rounds of quantitative easing (QE1, QE2, QE3), plus Operation Twist.

In the process, the Fed’s balance sheet has increased rather significantly, rising from $869 billion in August, 2007 to $4.5 trillion today. That's a 450% increase in just eight years.

Yet, all of these absolutely massive Federal Reserve stimulus programs, which were intended to re-inflate the economy, have barely made a difference.

Here’s a look at the last eight years of US economic growth, according to the World Bank:

2007: 1.8%
2008: -0.03%
2009: -2.8%
2010: 2.5%
2011: 1.6%
2012: 2.3%
2013: 2.2%
2014: 2.4%

This continued weakness, coupled with stagnant wages and incomes, has lowered the standards of living for millions of Americans.

The US economy is driven by consumer spending, which accounts for roughly 70% of GDP. Yet, consumers are in no position to be the engine that brings this economy roaring back to life.

Household incomes are the same now as they were in 1995, after you adjust for inflation. That means that the typical American family isn’t any better off now than 20 years ago.

Consequently, Americans have substituted debt for income growth in recent decades.

Average household debt, though below pre-Great Recession levels, is much higher than it was three decades ago.

According to the Federal Reserve’s Survey of Consumer Finances, after adjusting for inflation, the amount of debt held by the average family nearly doubled from $47,356 in 1989 to $91,114 in 2013.

Additionally, household debt as a share of GDP has increased by roughly 20 percentage points over that same time period, from around 60 percent in 1989 to just above 80 percent in 2013.

The economy needs continually increasing demand and consumption to keep growing. When consumers can’t create enough demand to spur sufficient growth, the government typically steps in.

But, with a national debt in excess of $18 trillion, further deficit spending is no longer a reasonable option (and it wasn’t many trillions ago either).

As it stands, debt growth is outpacing economic growth. That’s a terrible, and unsustainable, situation.

The federal budget deficit for fiscal 2015 (which ends Sept. 30) is expected to drop to roughly $425 billion, according to a report released last month by the nonpartisan Congressional Budget Office (CBO).

If so, it would be a seven-year low for the government’s annual budget shortfalls.

Last year’s deficit was $483 billion, 2.1 percent of gross domestic product, the lowest level since 2008.

If this year's lower deficit sounds like good news to you, ask yourself why $425 billion in deficit-spending in a single year can be considered good news.

Yet, if it wasn’t for that $425 billion in deficit spending this year, and the nearly half-trillion in deficit spending last year, our economy would most certainly be in recession.

Our economy is entirely reliant on debt to keep functioning.

Since all money is loaned into existence, money equals debt. The economy cannot grow without an expansion of debt, meaning that debts can never be fully retired. If debt isn’t accumulating, then money isn't being created and the whole system locks up and shuts down.

And therein lies the problem: Ours is a debt-based economy, and without continually expanding debt at all levels — consumer, corporate and government — there can be no return to what was once viewed as "normal."

In short, there can be no economic growth without debt.

It’s quite likely that without all of the government’s continual deficit spending, we’d be in the midst of a long term depression.

Advanced economies are mature economies, and are therefore harder to grow. The hard reality is that the low growth rates of last eight years are likely just the beginning of a longer-term period of lower, perhaps even zero, growth.

The Federal Reserve has undertaken massive, extraordinary, and rather drastic measures to get the economy out of recession and resume vigorous growth.

Yet, their nearly seven-year efforts have largely failed, and that is a troubling reality.

We are witnessing the limits of monetary policy. This is the best that it can do.

Why the Fed's Desired Interest Rate Hike Matters So Much

In December 2008, the Federal Reserve set its benchmark interest rate close to zero as a way to bolster the economy. The rate has remained there ever since.

Leaving the rate that low, for this long, is unprecedented. In fact, the last time the Fed raised interest rates was in June 2006.

Now the Fed wants to raise its key interest rate — the federal funds rate — which has been set between 0.00% and 0.25% for nearly seven years. That has led to increased volatility and instability in the stock markets.

Why?

When interest rates are this low, even small increases make a big difference.

Very small absolute changes in interest rates are proportionately large when the primary interest rate is so low.

That’s why the market has been thrown into such turmoil in recent months over the prospect that the Fed will soon rise its key interest rate — likely by no more than a mere quarter point.

The federal funds rate is the amount banks charge each other for overnight loans. It is set by the Federal Reserve through its purchases and sales of short-term Treasuries in trades with commercial banks.

The Fed typically raises or lowers the funds rate in quarter point increments.

If the funds rate increases from 0.25% to 0.50%, the rate effectively doubles. That’s why the markets are freaking out. A quarter point is typically a small movement, but when the funds rate is as low as it is now, a quarter-point hike is relatively huge.

If, for example, the 10-year Treasury moves from 2% to 2.25%, that quarter-point increase actually represents a proportional increase of 12.5%, which is substantial.

However, when the 10-year is at 5%, a quarter-point increase isn’t nearly as impactful.

By setting the funds rate near zero, the Fed went as far as it could with its main tool for guiding the economy. Since the Fed could no longer use interest rates to stimulate the economy, it was effectively out of ammunition.

When rock bottom interest rates didn’t have the intended effect, the Fed then used a strategy known as “quantitative easing” (QE) to try to stimulate the economy.

Employing QE, the Fed created money to buy Treasuries and mortgage securities in an effort to bring down long-term rates even further. Ultimately, the Fed utilized QE three times — QE1, QE2 and QE3, as well as “Operation Twist.”

The strategy led to a stock market bubble, pumped up the housing market (perhaps another bubble), and led to lots of mortgage refinancing.

Yet, the economy continues to muddle along, with an annual growth rate of roughly 2%.

When the next financial crisis or economic downturn occurs (and we all know it’s coming), the Fed will have one less tool to employ with its benchmark rate near zero. That’s why it desperately wants to raise the funds rate as soon as possible.

The problem is that outside forces are stymying the Fed’s plans.

The global commodities crash is creating deflationary forces, which makes raising rates a bad idea (central banks generally cut rates to fight deflation).

Additionally, the global stock market rout has everyone worried right now. The entire global economy is slowing (for example, Japan, Brazil and Canada are all in recession), which will likely affect the US at some point.

When that moment arrives, the Fed wants to be ready to act by cutting interest rates again.

But it can’t do that until it raises them first.

Kind of a nutty situation, huh?

With the funds rate so remarkably low, the Fed is performing a high wire act at present, and desperately hoping to avoid global cross winds.

That's an unlikely prospect right now.