Submitted by Nick Kaman of Letters from Norway
Norwegians are just now starting to grapple with the effects of their “single cylinder” economy, mostly dependent on oil and gas (ca. 60% of exports). Despite optimism about $50-$70/barrel oil, American crude output is surging, on track to be the highest ever, since 1970, while cracks start to form in OPEC’s latest agreement. In addition to the oil tailspin, a flock of “black swans” have taken flight, led by one with a very orange beak.
The global sovereignty movement is in full swing. People are finally asking about the role of government, what they are getting in return for their taxes, and what they can do at home. The Chinese economic risks as well as the continued fracking proliferation, now going global, pose the greatest threat to oil prices in 2017. That is already evident in the latest supply report. Meanwhile, Norway continues to spend its’ savings instead of investing it into a new economic engine. Even worse, individual Norwegians keep digging themselves into debt.
Oil: Global Fracking Proliferation:
When OPEC challenged America, it forced the engineers on the Great Plains to innovate. Fracking continues to get better cheaper and faster, driving the costs down to $45 per barrel! Now the technology is going global, bringing more oil to market. That may explain the surging inventories.
The chart above illustrates that when oil held $50 per barrel, the rigs started to come back online markedly, proving that fracking breakeven costs fell substantially. Innovation and cost reduction are now a way of life for the American Roughnecks. Moreover, there are almost 2000 more rigs standing by. Rarely acknowledged are the breakeven costs lowered by bankruptcy and the subsequent reassignment of assets. For example: If Joe’s Fracking Service purchased a brand new rig for $1000 and then went bankrupt during the last downturn, the rig and accompanying exploration data still remain. At a fire sale, Jimmy’s Energy can pick up that rig for $300-$400, if not cheaper, and start drilling at a much lower cost level, making money even with low prices. Perhaps that explains the surging inventories. Hence, the EIA predictions (below) may be overly optimistic.
On a side note: Although Norway’s Johan Sverdrup field now breaks even at $20-$30 per barrel and is one of the largest discoveries made on the Norwegian continental shelf (2-3 billion barrels of oil in reserves), the Norwegian Government requires $70 per barrel oil to break even, balancing the budget. Statoil estimates that construction will take 51,000 man-years (ca. giving 17,000 people a job for three years) and 2,700 man years in the production phase (ca. 54 people a job for 50 years). After going online, it will account for 25% of total Norwegian oil production. Putting this find, ca. 3 billion barrels, into perspective, America consumes 7 billion barrels of oil per year. Hence, Sverdrup, spread over 50 years, may buffer the economy but not save it.
Trade: Fishing for Deals:
After oil and minerals, fish is the next largest export. 2016 was the year of awakening: With the lowest trade surplus in 17 years, The Norwegians realized their vulnerability to the oil and gas sector.
The chart below further illustrates the oil dependency predicament. The trade surplus is what made Norwegian’s rich, giving them a strong currency and funding the welfare state without consequences. That allowed for some of the highest salaries (before the oil bust) in the world while maintaining the shortest work weeks. As the trade surplus diminished, the NOK went down with it. Overall 2016 exports were $90 billion vs. $149 billion in 2013.
Source: SSB.no and Norges Bank for FX Rates
A weakened currency, in theory, is good for exports. However, one needs something to sell abroad to take advantage of that. Since early 2013, the NOK fell 46% against the USD, moving from ca. 5.7 to 8.3 now. It almost hit 9, just after New Year 2016! Ironically, Norway was exporting more and running a larger surplus when the currency was stronger.
Source: Yahoo Finance – USDNOK over 10 years.
Realizing that oil, priced in dollars, was not viable, no matter the exchange rate, the Norwegian Government started to panic. Instead of looking for ways to industrialize or make the economy smart, “they went fishing.” Although fish exports are rapidly growing, they are still relatively small, compared to overall exports: only around $11 billion in 2016. Moreover, they already forgot that commodity-based economic models are either be overcome with technology or replicated. Fish farms only require and open ocean, preferably in cold water, and a pen. It is a matter of time before people in Maine, New Foundland, Alaska, Russia and Greenland pick up on this trend. Moreover, large-scale salmon farming has its’ own issues like sea lice, which have plagued the fish farms in recent years.
From a position of disadvantage and without leverage, at the behest of the fishing industry, they started selling out everything to gain access to new seafood markets. Currently, the Norwegian government is selling their souls to China, agreeing not to criticize them on human rights, and their brains to India, potentially compromising domestic labor standards to accommodate cheap offshore labor. Over time, such deals will diminish Norway’s national identity as a humanitarian country.
Moreover, the “fish for brains” deal with India will deter Norway’s best and brightest from entering the engineering profession altogether, fearing offshore replacement and limited salary potential. Right now Norway is in dire need for homegrown talent, with a vision, innovating and moving the country forward and away from resource dependence. If the Government compromises labor standards to appease the fishing industry, the best and brightest will choose other professionals or go abroad, seeking higher pay and a better life. Engineering has been a part of Norway’s history, selling it off is a bad idea!
One great example of Norway’s engineering ability is in their defense sector. One company, in particular, is very interesting; Kongsberg Gruppen which has been growing through both by increasing sales and performing acquisitions. Their surface to air missiles system protects President Trump! Considering the current state of the world and where it’s going, this sector should be developed. Additionally, defense technologies often result in consumer applications: sensors, security, and electronics. Norway will increase defense spending in coming years, reaped from cost-cutting in other areas, hinting that they are at least moving in the right direction on industrial development. Hence, this industry should be emphasized: not fishing.
Interest Rates & Inflation and the Wealth Fund
Despite real interest rates and economic growth remaining negative for almost four years, there is no indication of raising rates to curb inflation or lowering them to continue support housing. Nevertheless, the bias remains downwards, willing to step in if needed (indicated in a September release by Norges Bank). Although interest rates are at historical lows, Norwegian economic growth remains anemic. Just like with the exchange rates and exports paradox mentioned earlier, low-interest rates are not helping the economy. It’s only boosting inflation, caused by having to pay more for imports due to cheaper currency.
Source: Norges Bank and SSB
Norway started cashing in the Sovereign Wealth Fund in 2016, denominated in foreign currency. Norges Bank needed to buy NOK to fund the local economy, unintentionally supporting the Krone. Perhaps these purchases are all that kept the Norwegian Krone from turning into the Nordic Peso. The purchases started in October 2014 at 500 million NOK per day, quickly jumped to 700 million and now reached 1 billion NOK per day. At this level, the fund has 20 years, assuming stocks and bonds remain stable and they don’t hike the daily purchase rate again. That is only one generation of the good life left! However, the market’s tone has turned markedly bearish: Larry Fink of BlackRock recently warned about hidden risks (the “Horrifying” Chart) Ironically, Norway is a labor country that depends on strong corporate earnings. As American companies start paying their employees better, bringing more money to the middle class, the corporate profits will suffer, perhaps impacting the fund.
Norges Bank sold all of its’ gold in 2004, but perhaps they should think about buying it back. Although off highs in USD it’s at near all-time highs in NOK.
Although the government reined in the budget compared to previous years, the surplus (source 32 below) is the lowest in ten years. Moreover, the expenditure per person (Budget/Person) has dropped substantially due to rapidly rising population on the back tax revenues, which have not risen in lockstep. Every Norwegian has almost $170,000 in national savings, but when considering the local prices, it won’t last long. Although having an economy buffered better than any other in the world, the policy makers need to make a strategic shift. Otherwise, Norway will diminish over time. The risk of social unrest lingers along this path: when people see a reduction in benefits or a decline in the quality of public services.
Norwegian Housing Sucking the Life out of the Economy
It is not only becoming apparent that housing is in a bubble but also that it is starting to suck the life out of the rest of the economy. The media and banks are finally making the admission that the current prices are interest rate driven: a 1% rate hike would plunge 70,000 households into dire straits. (Note, from above, that real interest rates are currently -3%, requiring that much adjustment in the opposite direction to balance inflation and interest rates.) Despite the macro risks and black swans lingering overhead, Norwegians are pouring their heart and souls into buying apartments. Despite Norwegians already having some of the highest household debt to income in the world, some are starting to take “piggyback loans,” using consumer credit to fund down payments. The frenzy is reaching a point that now other parts of the economy are starting to suffer:
First, we can see that, although consumer debt is rising, it appears to be fueling housing and not the retail sector at all.
Despite the rapidly rising population, almost up almost 20% since 2002, the retail indexes haven’t kept pace and now started to turn down after holding steady since 2014.
Housing Reality Check
Interestingly, despite the meteoric rise in Oslo housing prices, the prices remain well off highs in US Dollar and Gold terms!
Sources for both charts: Statistics Norway, Norges Bank & Kitco
Capitalization rates and Price to Income ratios offer telltale signs of trouble ahead. Norwegians went from spending 4x earnings to 6x earnings to buy a place while seeing the return rate take a dive, indicating that there is growing rental supply. The rental market generally leads housing prices (i.e. like a PE ratio for housing).
Despite the spending on housing, Norwegian salaries have flattened in NOK terms and took a dive in USD.
Anecdotally, I have personally seen in Oslo a lot more vacancies in retail and office space. A friend who works in real estate told me that she normally requires a five-year commitment for commercial space, but recently did a deal, requiring only one year. On my bus trip to work, I see advertisements for entire floors in office parks where there was once a lot of oil services companies. Therefore, the crunch has already hit the commercial sector. Personally, my salary, determined by unions and corporate policy, only went up 2.4% last year while inflation averaged 3.5%. Therefore, overall productivity is not rising.
In the book, “Think and Grow Rich” by Napoleon Hill, he states that fear of destitution is one of the greatest contributors to anxiety, causing lack of sleep and driving erratic behavior. Stressed people, paralyzed with indecision, doubt, and fear, cannot form friendships, use their imagination or remain self-reliant. Innovative people generally have their finances in order and free from fear of poverty. When the entrepreneurs started in their garages in Silicon Valley, the garages were mostly paid off, or the mortgage burden wasn’t significant. Moreover, being in debt makes it more difficult to strike for new wages as union members cannot afford a lot of unpaid time off.
The condition, hunkering down into survival mode, often leads to less than honest behavior. Although Norway still remains lofty on egalitarian values, altruism, and honesty, it is starting to slip: losing one place in the corruption ranking to sixth place, ranking last among Nordic countries. Considering the wealth and short work weeks, they should be number one.
I personally feel a lot of tension in the office, more so than in previous years and noticed an uptick in “political behavior,” where people’s personal agendas come before the needs of customers and shareholders. This may be rooted in the stress associated with indebtedness and uncertainty about the future. The picture below perhaps illustrates a new desperation that is starting to form:
Considering the current government leaders (Erna Solberg (PM), Siv Jensen (Finance Minister), Øystein Olsen (Head of the Central Bank) Børge Brende (Foreign Minister)) insular educational background and private sector business experience, we should not expect an imaginative and visionary path to the future. Choosing between the Krone and housing prices, they will choose housing. However, the NOK’s decline will continue to be curbed by open market Krone purchases, moderating the decline over twenty years. Nevertheless, that estimation could be shortened if they increase public spending and benefits to appease voters.
Once the interest rate lever has been exhausted, used to support housing and boost exports, they may introduce 50 and 100 years mortgages like in Sweden. In essence, down payments will become a reservations fee, entitling one to pay rent for a lifetime but with one huge disadvantage: being tied down in a slowing economy, unable to move to take a new job. Moreover, the lower foreign exchange rates, which will transform the NOK (Norwegian Krone) into the NOP (Norwegian Peso) will make it difficult to attract the truly highly skilled immigrants. They are needed to work with local best and brightest to make the Earth moving breakthroughs. These type of people, having an IQ over 142, only occur only in 1/400th of the overall population. Norway must compete against America, Germany, and Japan for such talent. That requires a strong exchange rate and high quality of life.
As long as real interest rates remain negative, gold and dividend paying, export related, stocks are looking bright.