Oil Price: A Small Boat On The Sea By - 19 Dec 2008

The price of oil has been brought low by the collapsing global
economy as we all know.  What next?  To see how far the economy may
have to fall (and thus how long we can expect the oil price to be under
pressure from reduced demand), let’s look at the bursting bubbles that
are causing the economy to implode.  They include a bubble in housing
construction and housing prices; a bubble in financing - both stocks
and credit expansion; and a bubble in executive compensation. 

The first two bubbles have been extensively discussed and analyzed. 
Let me spend a minute on the executive compensation bubble since it
rarely gets attention in the press and it has had huge impacts on the
economy.  Few economic commentators recognize that one driving force
for U.S. economic growth has been outsized compensation, mostly of
executives, with stock options that have floated upwards in value for
many years.  Stock option gains have pushed corporate compensation far
higher than historical norms and I would argue, far out of line with
the value of the work product of these people. 

Stock options have gone from a fringe benefit for top management to
a growing staple of executive compensation.  It became an annual ritual
for executives to give themselves new options.  As the process evolved
and as stocks rose nearly every year, executive would annually exercise
the options that were profitable, sell their shares and then issue
themselves new options.  So if you looked at the record of insider
purchases and sales of nearly all public companies there would
constantly be slews of sellers and hardly any buyers.   Who needed to
buy shares of the company you work for when you are given options for
free every year?  

The net effect was that millions of people working for public
companies have for years been pulling enormous sums of cash out of the
public stocks of their companies, a cost that was never adequately
reflected in the earnings of the companies or in any other way.  Many
tech companies, like Google, for example, compensated virtually all
their employees with options.  In such cases, literally thousands of
new millionaires were manufactured in the past decade.   Perhaps such
fortunes were warranted when truly world-changing companies like Google
were built by hard working young people.   But the greatest amount of
stock option compensation was given to executives of ordinary companies
that simply benefited from rising stock prices since 1982 based in part
on the the rising credit, tech, and housing bubbles.  

The poster child of excessive compensation was the $400 million
option compensation for Rex Tillerson, the recently retired Chairman of
Exxon.  Tillerson may have run a tight ship but it is questionable
whether Exxon’s strategy of sticking with oil rather than developing
alternative energy has been good for stockholders long term.  In any
case, Tillerson had nothing to do with the rise in oil prices that led
to higher prices for Exxon shares and thereby allowed Tillerson to walk
away with a king’s ransom of excessive compensation.   What makes this
a bubble is that Tillerson’s compensation is mirrored many thousands,
probably millions, of times - usually but not always in lesser amounts
- among “executives” of thousands of public companies.

What happened to all that cash?  Some was consumed - vacations,
cars, etc - and a lot of it was spent on first, second and third
homes.   Those homes had a multiplier effect on other industries -
furnishings, white goods, developers, brokers and lawyers, advertising,
etc.  It created many sub-bubbles along with contributing to the bubble
in housing prices.  Sure, housing prices rose partly due to looser
lending standards.  But an important source was wildly excessive
corporate compensation derived from stock options. 

Now that the end of all these bubbles (housing, financing, stock
option gains) has come simultaneously (because they were all related)
the economy needs to fall to a level that is sustainable without such
bubbles.  How much of a fall is that?  5% of GDP?  That seems easy. 
10%?  Perhaps.  20%?  That seems too much.  After all, we still have
perfectly viable industries that will continue operating near the peak
of their output:  agriculture, education, medicine, law enforcement,
food distribution, necessary housing, government, media, entertainment,
transportation, technology.  Much of that output is also valued in
other parts of the world economy and so enjoys export demand.

Sure, many of these industries are slowing down.   But they will not
collapse like the worlds of finance, home construction, or luxury goods
and services.  In other words, as we step back from the economy and
look at where it needs to contract, we see that it needs to contract
primarily in the areas that were propelled by the wealthy class.  Those
are the folks who have been overcompensated for so many years, who have
been overspending for so many years, and whose assets are in the
process of contracting. 

If the top 20% of U.S. economic activity generated by the wealthy
needs to contract by, say, 25%, that’s only 5% of GDP.  If that
trickles down to the next 40% contracting by 5%, that gives us another
2%.   And maybe we get a bit more  from the non-consumer spending part
of the economy.   So it seems like an 8 - 10% decline in GDP would be
more than adequate to get us to the level of a sustainable economy. 

Shrinking the U.S. economy by 8 - 10% is a huge adjustment that will
take a couple of years at the least to accomplish.  Right now U.S. GDP
is declining at a 5% annual rate.  If we need two years of such a
decline, that suggest we may start to bottom some time in 2010. That
suggest that the price of oil might stay under pressure for a couple of
more years in terms of demand declines.

But we don’t live in a static world.  Clearly the Obama team thinks
they can shortcut the downturn by exploding federal spending.   That is
going to have a catastrophic impact on the U.S. federal deficit.  
Moreover, the Fed has pushed short rates to

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