In a normal economic times falling energy costs would be considered unadulterated good news. The facts are simple. No one buys a barrel of oil to display above the mantle. No one derives happiness from a lump of coal. Energy is simply a means to do or get the things that we want. We use it to stay warm, to move from Point A to Point B, to transport our goods, to cook our food, and to power our homes, factories, theaters, offices, and stadiums. If we could do all these things without energy, we would happily never drill a well or build a windmill. The lower the cost of energy, the cheaper and more abundant all the things we want become.

 
This is not economics, it is basic common sense. But these are not normal economic times, and the mathematics, at least for the United States, have become more complicated.
 
Most economists agree that the bright spot for the U.S. over the past few years has been the surge in energy production, which some have even called the "American Energy Revolution". The stunning improvements in drilling and recovery technologies has led to a dramatic 45% increase in U.S. energy production since 2007, according to the International Energy Agency (IEA). And while some suggest that the change was motivated by our lingering frustration over foreign energy dependence, it really comes down to dollars and cents. The dramatic increase in the price of oil over the last seven or eight years, completely changed the investment dynamics of the domestic industry and made profitable many types of formerly unappealing drilling sites, thereby increasing job creation in the industry. What's more, the jobs created by the boom were generally high paying and full time, thereby bucking the broader employment trend of low paying part time work.   
 
The big question that most investors and drillers should have been asking, but never really did, was why oil rocketed up from $20 a barrel in 2001 to more than $150 barrel in 2007, before stabilizing at around $100 a barrel for much of the past five years. Was oil five times more needed in 2012 than it was in 2002? See my commentary last week on this subject.
 
Despite the analysts' recent discovery of a largely mythical supply/demand imbalance, the numbers do not explain the rapid and dramatic decrease in price. Yes, supply is up, but so is demand. And these trends have been ongoing for quite some time, so why the sudden sell off now? Instead, I believe that oil prices over the last decade has been driven by the same monetary dynamics that pushed up the prices of other commodities, like gold, or of financial assets, such as stocks, bonds, and real estate. I believe that oil headed higher because the Fed was printing money, and everyone thought that the Fed would keep printing. But now we have reached a point where the majority of analysts believe that the era of easy money is coming to an end. And while I do not believe that we are about to turn that monetary page, my view is decidedly in the minority. Could it be a coincidence that oil started falling when the mass of analysts came to believe the Fed would finally tighten? 
 
If I am wrong and the Fed actually begins a sustained increase in rates starting in 2015, oil prices may very well stay low for a long time. But apart from the fact that our broad economy can't tolerate higher interest rates, an extended drop in oil prices may create conditions that further force the Fed's hand to reverse course.
 
If prices stay low for very long, many of the domestic drilling projects that have been undertaken over the past few years could become unprofitable, and plans for further investment into the sector would be shelved. Evidence suggests that this is already happening. Reuters recently reported a drop of almost 40 percent in new well permits issued across the United States in November (this was before the major oil price drops seen in December).

This huge negative impact on the primary growth driver of U.S. economy may be enough in the short-run to overwhelm the other long-term benefits that cheap energy offers. If prices stabilize at current levels, then the era of triple digit oil may, in retrospect, be looked back on as just another imploded bubble. And like the other burst bubbles in tech stocks and real estate, its demise will make a major impact on the broader economy. But there is a crucial difference this time around.
 
When the dot-com companies flamed out in 2000, most of the losses were seen in the equity markets. Dot-coms either raised money either through venture capitalists or the stock markets. They rarely issued debt. The trillions of dollars of notional shareholder value wiped out by the Nasdaq crash had been largely paper wealth that had been created by the sharp run up in the prior two years. As a result, the damage was primarily contained to the investor class and to the relatively few number of highly paid tech workers and entrepreneurs that rode the boom up and then rode it down. In any event, the Fed was able to cushion the blow of the ensuing recession by dropping rates from 6% all the way down to 1%.
 
The real estate and credit crash of 2008 was a much different animal. Despite the benefits that lower home prices may have brought to many would be home-buyers who had been priced out of an overheated market, the losses generated by defaulting mortgages quickly pushed lending institutions into insolvency and threatened a complete collapse of the U.S. financial system. Unlike the dot-com crash, the bursting of the housing bubble posed an existential threat to the country. The construction workers, mortgage brokers, landscapers, real estate agents, and loan officers who were displaced by the bust represented a significant portion of the economy. To prevent the bubble from fully deflating, the Fed bought hundreds of billions of toxic sub-prime debt (that no one else would touch) and dropped interest rates from 5% all the way down to zero. 
 
I believe, a bust in the oil industry will likely play out somewhere between these two prior episodes. As was the case with falling house prices, while low prices offer benefits to consumers, the credit and job losses related to unwinding the malinvestments, made by those who believed prices would not drop, can impose severe short-term problems that the Fed will be unwilling to tolerate. Of course, long-term it's always good when a bubble pops, it's just that politicians and bankers are never prepare to endure the short-term pain necessary for long-term gain when they do.
 
A good portion of the money used to finance the fracking boom was raised by relatively small drillers in the debt market from banks, institutional investors, pension funds, hedge funds, and high net worth wildcatters. Public involvement has been involved primarily in the high yield debt market where energy companies have issued hundreds of billions of "junk" bonds in recent years. In 2010, energy and materials companies made up just 18% of the US high-yield index but today they account for 29%.
 
But many of the financing projections that these bond investors assumed will fall apart if oil stays below $60. Although the junk bond market is nowhere near as large as the home mortgage market, widespread defaults from energy-related debt could cause a crisis, which could make wider ripples throughout the financial edifice. Bernstein estimates that sustained $50 oil could result in investment in the sector to fall by as much as 75%. According to the Department of Labor, oil and gas workers as a percentage of the total labor force has doubled over the past decade, and have accounted for a very large portion of the high-paying jobs created during the current "recovery." As a result a bust in the oil patch will result in a very big hit to American labor, causing ripple effects throughout the economy.
 
But we are far less able to deal with the fallout now of another burst bubble than we were in 1999 or 2007 (the years before the two prior crashes). I believe it will take much less of a shock to tip us into recession. But I don't even believe that a burst energy bubble is even our biggest worry. Much greater and more fragile bubbles likely exist in the stock, bond and real estate markets, which have also been inflated by the easiest monetary policy in history. More importantly at present the Fed lacks the firepower to fight a new recession that a bursting of any of these bubbles could create. Since interest rates are already at zero, it has no ability to aggressively cut rates now in the face of a weakening economy. All it can do is go back to the well of quantitative easing, which is exactly what I think they will do.  
 
Despite the widely held belief that 2015 will be the year in which a patient Fed finally begins to normalize rate policy, I believe the Fed has no possibility of withdrawing the stimulus to which it has addicted us. QE4 was always much more probable than anyone in government or on Wall Street cares to admit. A recession and a financial panic caused by sub $60 oil will significantly quicken the timetable by which the Fed cranks up the presses. When it does, oil could once again increase in price, along with all the other things we need on a daily basis. That should finally dispel any remaining illusions that the Fed could successfully land the metaphorical plane. More QE may minimize the damage in the short-term, but I believe it will keep us trapped in our current cocoon of endless stimulus, where we will slowly suffocate to death.

Best Selling author Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital. His podcasts are available on The Peter Schiff Channel on Youtube

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 -- Published: Monday, 22 December 2014 | E-Mail  | Print  | Source: GoldSeek.com

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Mr. Schiff is one of the few non-biased investment advisors (not committed solely to the short side of the market) to have correctly called the current bear market before it began and to have positioned his clients accordingly. As a result of his accurate forecasts on the U.S. stock market, commodities, gold and the dollar, he is becoming increasingly more renowned. He has been quoted in many of the nation's leading newspapers, including The Wall Street Journal, Barron's, Investor's Business Daily, The Financial Times, The New York Times, The Los Angeles Times, The Washington Post, The Chicago Tribune, The Dallas Morning News, The Miami Herald, The San Francisco Chronicle, The Atlanta Journal-Constitution, The Arizona Republic, The Philadelphia Inquirer, and the Christian Science Monitor, and has appeared on CNBC, CNNfn., and Bloomberg. In addition, his views are frequently quoted locally in the Orange County Register.

Mr. Schiff began his investment career as a financial consultant with Shearson Lehman Brothers, after having earned a degree in finance and accounting from U.C. Berkley in 1987. A financial professional for seventeen years he joined Euro Pacific in 1996 and has served as its President since January 2000. An expert on money, economic theory, and international investing, he is a highly recommended broker by many of the nation's financial newsletters and advisory services.

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