COVID-19 has made a tremendous impact on the economy, world-wide. The US economy is in a deflationary environment and money velocity has been reduced to almost nothing. Deflation can lead to economic stagnation and periods of high unemployment. That is because deflation can discourage spending due to people believing goods and services will be cheaper in the future. This leads to a decrease in money velocity. Money velocity is the measurement of how frequently consumers exchange money in the economy. Expressed another way, money velocity is the turnover of money. The savings rate, which is the percentage of personal income consumers save rather than spend, is at the highest it has been in years. The high savings rate is a reflection of the American peoples’ fear because they do not know the direction the economy is going to take.
The action taken since March by the Federal Reserve, in cooperation with the US Treasury, has increased the M2 money supply by 3 trillion US dollars. The US has in excess of 18 trillion USD of M2 money supply available. M2 money supply is the total money available in an economy at any given point. This includes cash, mutual funds, savings deposits, and near money (highly liquid assets that can easily be turned into cash). The US Dollar has been weakening recently, relative to other currencies. This is due to the FED’s action of cutting interest rates to zero and dramatically increasing the money supply.
While the excess capacity in the economy and the decrease in money velocity has led to a deflationary environment for the time being, it is expected that a condition of stagflation will be in the cards at some point in the future. Stagflation is a condition where the inflation rate is high, economic growth is slow, and unemployment remains steadily high. In order to see the increase in inflation, there must be an increase in money velocity. This is expected to happen in the future once the virus is brought under control. We need to next explore just how the US government was able to supply the financial system with 3 trillion dollars.
The government in and of itself cannot generate revenue; it must largely tax people to bring in money. With so many people out of work, how did the US government produce 3 trillion US dollars worth of stimulus packages? Well, they printed US dollars out of thin air. Anytime the US government prints money out of thin air, the US dollar is likely to devalue against other global currencies, all things being equal. You can see the increase in liquidity being reflected in the Dow Jones Industrial Average. Although the DJIA is increasing in nominal US dollar terms (Graph 1), the DJIA is losing value when measured in gold (Graph 2).
Why measure the value of the DJIA against gold? Because the US dollar is a fiat currency backed by nothing more than the full faith and credit of the US government. Gold on the other hand is real money and has been considered money for 5000 years. Gold is one of a few metals that exist on the periodic table that has all the properties of money. The US dollar currency is a representation of money; gold is a natural resource that holds the actual monetary value. Warren Buffet said it best: “Price is what you pay, value is what you get”.
Dow Jones Industrial Average: Priced in US Dollars
Dow Jones Industrial Average: Priced In Gold
Oil and Gas Industry
The US is still recovering from a decrease in demand for hydrocarbon and hydrocarbon finished products. When you look at total finished products like gasoline, jet fuel and other distillates, you will see the demand destruction that has occured (Graph 3).
With the overall supply being higher than consumer demand, finished product prices remain low. In order to survive, oil and gas companies are having to adjust operations both in the upstream and downstream sectors.You may have seen in the news recently that oil and gas companies are deciding to re-purpose some of their refineries. For example, some refineries are now processing soybean oil and other feedstocks to make biodiesel.
‘Refiners such as HollyFrontier Corp and CVR Energy are exploring opportunities to produce renewable diesel to save money on less profitable refineries and offset compliance costs associated with U.S. blending laws.’Reuters
This is not the only time that the Oil and Gas industry has adjusted to extreme stresses on global economies. Take for example, the Kingdom of Saudi Arabia. In the 90’s, Saudi Arabia was flaring a large volume of their produced natural gas. Due to the increase in population and domestic energy demand, they were having to generate more electricity than ever before. This led to a situation where they were having to use more diesel fuel (processed crude) to generate electricity in their power plants.
Due to this situation, Saudi Arabia did not have as much crude oil to export. In order to again increase the volume of crude oil for export, Saudi Arabia began a program to increase the amount of natural gas being used in power plants rather than just relying on diesel fuel. Therefore, less crude oil was being used for domestic purposes. With more oil available for export, Saudi Arabia brought in hard currency in the form of US dollars. This is because crude oil is priced in US dollars. It also allowed the Kingdom of Saudi Arabia to generate electricity at their power plants with a cleaner burning fuel source in the form of natural gas.
The Bottom Line
COVID-19 has had powerful impacts on the world’s economy. The US stock market is going down when valued in terms of gold. Over time and as the money supply continues to increase, the US dollar is likely to continue to weaken relative to other currencies. If history proves anything, gold prices in USD terms will also likely increase as the money supply increases. Finally, the Oil and Gas industry is having to adjust significantly in order to survive during this time of crises due to the COVID-19 pandemic. What is the ultimate outcome? Only time will tell.
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