Jerome Vitenberg warned, in an article dated December 25, 2013, about the consequences of excessive oil dependence. He questioned the economic sustainability and the underlying assumptions, supporting the nation’s $837 billion sovereign wealth fund (2015). Paal Bjørnestad, the Norwegian State Secretary replied in an article published January 9, 2014, that Norway’s wealth was well managed and discounted some of Vitenberg’s assertions. Vitenberg followed up with an article dated February 11, 2014. He advocated for increased transparency regarding Norway’s debt obligations against The Fund’s balance. What happens if, on Norway’s rainy day, The Fund’s value is much less than expected, because there is also a global crisis? The Fund’s allocation is mostly in North America and Europe and spread across equities and fixed income with some real estate allocation. Therefore, considering recent IMF warnings about the state of the global economy, I share these concerns. Moreover, the amount of debt, worldwide, both personal and public is alarming.
Digging into the data, especially the changes from 2014 to 2015, the crisis may already have arrived. We are starting to see key figures like exchange rates, unemployment, capitalization rates and dwelling prices relative to income break out of normal ranges. Personal debt also continues to grow, dampening purchasing power further. It is also important to note that Oslo’s population is around 30% immigrants, many of whom came to work, one of the key factors driving housing demand.
Key Indicators Dashboard (KID)
Norway’s central bank made a surprise rate cut on September 24, 2015, trimming 25 basis points to 0.75%. They stated support for the slowing economy due to oil’s rapid descent as the reason. They even warned that more cuts may be coming, further averting recession. Rate cuts are not something governments do when all is good. They are a quick fix, stimulating a sagging economy. They encourage consumers to borrow while discouraging savings, pushing more cash into the economy but do nothing to address the structural issues.
The paradigm shift in oil production is real and Norway needs a new economic engine. Encouraging borrowing and spending, especially on imported goods and vacations, increasing the trade deficit, is shortsighted. Easy money policies could even exaggerate existing problems, inflating bubbles more, making the day of reckoning worse.
The Norwegian Economy
Norway’s main source of wealth is oil and gas, accounting for over 64% of exports. They mostly import machinery and transportation equipment (cars, buses and locomotives) and (finished and manufactured) goods made abroad. From the street level, this is easy to see. People buy Chinese made goods from Swedish based retailers like Clas Oslon, IKEA, and H&M. Tesla’s Model S is Norway’s bestseller.
The Oil Cloud & An Iranian Comeback
Looking at the KID above, it is easy to dismiss the current situation as temporary, especially with The Fund’s current $827 billion (October 4, 2015) acting as a buffer. Norway did come back stronger than before from the 2008-2009 crisis. They even recovered from the toxic US mortgage-backed securities (MBS). However, the current crisis is not only from slowing demand, like in 2008, cyclical in nature but also from technology change. In addition, the Iran Nuclear deal, potentially adds more supply.
Fracking on the American Great Plains is like cloud computing. Many wells were drilled, breaking even in the $50-$60 range. Some even as high as $80, accounting for exploration. The current price route, causing consolidation, allows cash rich players to buy up existing assets and exploration knowledge at substantial discounts, lowering their cost basis. This is still playing out as price hedges expire. (Source: Interview with an Explorer at a major energy company)
Fracking wells can be turned on and off with relative ease. Therefore, just like Amazon Web Services (AWS) and storage, when demand rises, more rigs will come online, and when it falls, goes offline. Hence: “The oil cloud.” Traditional vertical wells, when restarted after a shutdown, yield far less output than before. Moreover, the underlying technology continues to improve, driving down operating costs. Software improvements optimize and automate production. “Re-fracking” or upgrading existing equipment increases existing well output, saving on costly exploration. Some sites are seeing operating costs dropping to $25 per barrel! This is well below $60-$70 per barrel, required to balance the Norwegian state budget. Therefore, it is not safe to assume that this is a fad, passing with time.
Currently, Norway runs a trade surplus, supporting a strong currency while building reserves. However, when oil prices started to route early last year, the trade surplus declined. It almost reached a deficit. Even the weakening Krone could not offset (boosting other exports) the weakness in the oil markets. Although trade deficits boost exports, they also weaken a currency, inflating import prices. The trade balance deterioration is moving in line with falling oil prices.
The most visible indicator, validating Vitenberg’s article, are foreign exchange (FX) rates since Christmas 2013. Moreover, gold appreciated 31% against the NOK whereas it has fallen 5.6% against the USD. Since most trade activity is with neighboring European countries (NOK declining 8-14%), the effects are not too noticeable – yet. As price hedges expire, we can expect inflation soon, increasing the cost of vacations, clothes and consumer goods.
The greater problem is that FX rates are not resting. They are still moving with the oil story. At first, economists thought that the decline was temporary, however, this time being different, it is structural in nature. If this trend continues unabated, Norway will slowly become more or less like other European countries, perhaps worse. If The Fund were to take a major hit Norway may appear more like Greece, if they do not cut government spending in-line with declining oil revenue.
Inflation Vs Interest Rate Policy
Since 2013, the inflation rate is higher than the benchmark interest rate. The government is trying to stimulate the economy, using policy tools discussed earlier. Most Norwegians have their wealth tied up in housing, using floating interest rate loans. Hence, the rate cuts will boost consumer spending, potentially pushing up inflation rather than future investment. We can see that after the 2008 inflationary spike, the central bank abruptly raised rates to compensate. Housing prices and the corresponding payments at lower interest rates are higher than before.
Jerome (Dan) Vitenberg brought to my attention another issue. DnB (Norway’s leading bank) stated that the falling krone is scaring off investors, creating liquidity issues. If this persists, they may have to raise rates, assuring bond investors. Recently, Russia and Ukraine have raised rates, amid the crisis, defending their currencies and enticing investors. However, once the crisis is underway and investors lost confidence, the rate becomes irrelevant, no matter how high.
The United States is the only country that can cut rates to near zero, holding them there since 2009, and then seeing their currency hold or even rise. The US Dollar enjoys world reserve currency status, backed by 10 Nimitz class aircraft carriers, a diverse population and economy, innovative culture and ultimate safe-haven perception. The rest of the world, including Norway, when selling bonds, must offer a return on investment exceeding inflation. Therefore, if (Norwegian) rates were to spike to quell inflation or address liquidity concerns, the effects for everyday people will be detrimental.
Consumer Debt & Housing
The central bank cut rates before and yet the Norwegian economy is still moving slowly. This is due to personal debt dragging on the real economy. The Nordic consumers are among the most indebted in the world, even more so than Americans. The Norwegian Financial Supervisory Authority warned that cutting rates to save housing could risk severe deleveraging in the future. Morten Baltzersen, head of the Norwegian Financial Supervisory Authority, questions how much higher housing prices can go. Although these ratios are high, they are not out of line when compared to Switzerland or the UK. However, those countries’ finances are also coming into question.
Employment: Housing’s Main Support
Stagnating salaries and rising unemployment, combined with rising import costs, could precipitate deleveraging. Employment and population growth generally drive housing prices. The Norwegian petroleum sector employed around 240,000 people or 9% of the population in 2014. They earn well. There used to be shortages in this sector, filled by skilled immigrants who not only earned well but also increased the population. They created new demand in housing and consumer sectors, therefore, any damage to this sector affects the overall economy.
The oil industry expects 40,000 layoffs this year. This could be just the beginning if oil settles below $70 per barrel, considered the break-even point by the Norwegian Central Bank. Loss of well-paid jobs affects other sectors also from loss of consumer spending. Moreover, this has affected skilled immigration, starting to recede after years of strong growth. Hence, overall unemployment in Norway is starting to tick up as skilled immigration declines. On a positive note, unemployment remains below 5%, considered a labor shortage. Immigration continues at historically high levels, pushing housing. Although the figures are not alarming now, the trend, showing deceleration, signals difficult times ahead.
The Sovereign Wealth Fund
The Norwegian Sovereign Wealth Fund, created for a rainy day (or decade), could be in a precarious position. The portfolio contains 60% equities, 35% fixed income and 5% real estate. Geographically allocated at 39% Europe, 39% North America, 18% Asia and 4% everywhere else. Currently, they run on the classic asset-allocation model assumption. If one stock or bond market is down, another will be up, offsetting the loss. We have seen in 2008 that a crisis can go global, hitting everything at once. Lately, the Global Dow, representing the world’s largest companies, with similar geographic allocation (47% USA, 29% Europe, 16% Asia and 8% everywhere else) decided to take a break on the back of worldwide pessimism. Global stocks have a habit of giving up gains just when you need the money most.
Many experts believe that the risks to the global economy have actually increased since then. Debt levels are higher than ever before while countries are doing one stimulus after another, moving into uncharted territory. If rates were to rise, responding to an inflationary spike caused by almost a decade of easing and stimulus, these types of holdings, irrespective of location, would tank. Stocks, bonds and real estate today generally thrive on low-interest rates.
If this happens, while oil prices remain subdued, the fund could be hit twice:
- First, with oil-related income trickling to a halt. We are already seeing some evidence that capital inflows into the fund have fallen off sharply, injecting only NOK 17 billion in the first half of 2015 versus an average of NOK 60 billion per quarter. Norges Bank started selling NOK 700 million per day in foreign exchange since September, covering the oil revenue shortfalls deposited into The Fund. In October, they made their first purchase of NOK, covering the government’s budget deficit.
- Second, if The Fund’s net asset value (NAV) drops. Much of it could just evaporate while policy makers sit and wait for the future. This would drastically change sentiment, leading to the feared massive deleveraging. The Fund declined in value by NOK 53 billion (around $6.7 billion) in Q2-2015.
Proactively Stabilize the Economy
The Norwegian government has the opportunity, money, and intellectual resources to engineer a “soft landing.” They can deflate the economy, in a controllable manner, to sustainable levels. By allowing bankruptcy, forgiving debt, they could bring down housing prices to ones associated with higher interest rates. This would quell potential run-away inflation, encouraging savings while reducing consumer debt. The banks, regulated by the government, through aggressive advertising, encouraged the public to borrow beyond their means. The government should be leading the effort, working with the banks, taking them over as needed, solving the problem before reaching a crisis point. Taking money out of housing encourages growth in other sectors. When people are not overly indebted, they tend to get creative, opening businesses, driving new industries.
The Fund, while high, should be used to invent a new economy, an industrial level alternative to making holes in the ocean floor. Walter Qvam, Kongsberg Gruppen CEO, stated that Norway must re-invent itself, inviting Guy Kawasaki to challenge their thinking. Kawasaki stated that Norway should think of itself as an energy nation instead of an oil one. Hence, they should be solving energy problems instead of just pumping and selling oil.
The Next Big Thing
After securing the population from a near-term crisis, Norway should do something big. Hydropower supplies 99% of Norwegian electricity. However, instead of exporting oil, they could export sustainable and green power generation solutions. Thorium nuclear power will take the country to the next level, ensuring their wealth for future generations. Thorium is abundant in Norway, holding 15% of the world supply. It cannot be weaponized. It produces less waste than Uranium while having a higher melting point, making it less prone to meltdown. The reactors can be mounted on ships, making them portable. Moreover, the excess heat can be used to safely desalinize ocean water (just like US Navy nuclear ships and submarines), refilling drought-stricken areas. Hence, they would also be solving the world’s fresh water problems. Offshore drilling and shipping industry knowledge could be leveraged, building this new industry, in the same manner as Kongsberg converted mining expertise into weapons manufacturing 200 years ago.
Making “killer apps”, hosting servers or fishing will not compensate enough for the declining oil industry. Despite conventional wisdom, the IT sector, although important and an economic driver does not actually contribute significantly to GDP. It is a necessary industry, but it cannot support an economy alone. For example, although growing fast, IT is only 6-7% of the Indian economy. The number for the USA is similar. Software and systems engineering enables other industries, making them more competitive, rather than an industry in of itself. IT has made manufacturing, agriculture, services and retail more efficient. Improvements in those industries significantly add to the GDP.
As long as Norway is a “one-trick pony,” depending on oil for the majority of prosperity, we should be concerned. The threats to offshore oil by new technologies and changing supply and demand fundamentals are very real. Jerome Vitenberg was right back in 2013. Today we can see that the crisis is already unfolding. The exchange rate against most currencies has fallen, almost collapsing against the US dollar. The immigration and employment supports for housing are weakening, and the central bank, using rate cuts, is desperately trying to prop up the housing market. They are muting the effects for now, but production and employment fundamentals will eventually prevail.
From eye level, walking the streets of Oslo, most are not feeling it. Norwegians earn in Kroner and spend in the same. In other countries, it is felt more because they borrow in one currency, Swiss Francs or Euro, then pay back in their local currency, getting hit hard when exchange rates move against them. Nevertheless, many think, deep down, that something is wrong but unwilling to discuss it. Others still say everything will be ok because of the “rainy day fund.”
All signs point to a fundamental change. Cutting interest rates and drawing from The Fund (around $827 billion) to meet budgetary shortfalls does not solve the underlying issues. It may actually make or even exacerbate an eventual crisis, boosting borrowing in an already over-leveraged economy. No one warns you the day before a crisis. In fact, they tell you that it has “never been better.” Sitting on a pile of cash, mostly invested into stock and bonds, tied to a more unified international economy, driven on debt, while global fundamentals deteriorate, is somewhat irresponsible. It is time for Norwegian policy makers to step-up, doing more than manage. More importantly, the people living, voting and paying taxes in Norway should demand more honest talk from their politicians. They must demand leadership.