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BusinessAnalysis

Seeking a bottom for an entire economic cycle: Don Pittis

It seems pretty clear that something's got to give. We should be producing less oil but no one wants to be the first to capitulate.

Must we suffer the painful changes of capitulation for recovery?

Terra Green, who was seeking a job last week in the previously booming Bakken oilfield on the Saskatchewan-North Dakota border, found that she was too late. (Andrew Cullen/Reuters)

As oil concluded a bad week with aplunge of nearly $2 a barrelon Friday,it seems pretty clear thatsomething's got to give.

"Everyone was assuming that Russia and/or the North Sea or somewheresome of these mature basins would have seen dramaticdeclines [in production] because of those low oil prices," said Citigroup's topenergyanalyst Seth Kleinman in a recent interview. But it hasn't happened yet.

Stock traders sometimes talk about capitulation,a moment when markets give up all hope of recoveryand finallycollapse. As oil, stock markets, the loonieand perhaps the entire world economy, tumblefrom low to new low, it may be that we need to see real signs of surrender before the world can bounce back again.

In his book The Upside of Down Canadian author ThomasHomer-Dixon describes something he callscatagenesis, where "catastrophe is followed by creativity and eventual renewal."

Cleansing fire

Seen in the grand sweep of history, a devastating war or afire in a great city that allows its citizensto rebuild an even better citymay seem worth the sacrifice. Such events are hell to live through.
Good things can come out of a crisis, but few people willingly accept the consequences. (Reuters)

In his book Homer-Dixon must have captured a mood. He published it in2007 as if anticipatingthe great market meltdown from which the world is still strugglingto recover.

But at the time it appeared Homer-Dixon was wrong.Rather than a crumbling followed by renewal, the world's governmentsmerely flooded the market with more money,keeping the oldsystem running. There was no catagenesisbecause there was no catastrophe.

With so many opinions in this wide world, inevitably there are those who are impatient for the Marxist crisis of capitalism thatwill bring us into anew world order. Those who read history and understandthe destructive power ofprevious economic and social breakdowns are less likely to wish for a new one.

The current market for oil is a less portentous example that helps to illustratethe economic pressures that come to bear.

Blinking last

There is so much at stake for oil-producing countriesthat none wants to be the first to cut production. Even at current prices below$30 a barrel, countries such as Venezuela and Russia, to name just two prime examples, are so dependent on foreign exchange from oil exports that they are under pressure keep selling despite the falling price.
People line up to buy basic products outside a supermarket in Caracas, Venezuela last week. The plunging price of oil is hurting, but production remains high. (Reuters)

In developed countries, including Canada, private companies alsocontinue to produceeven after the price they earn is less than the cost of production.

AsKleinmanpoints out, Russian oil production finished the year at an all-time high. All we have seen so faris a slight cutback in U.S. shale drilling. At the same time, Kleinmansays,emerging markets such as Brazil that drove the oil and commodities boom as they consumedmore and more arenow shrinking, meaning that demand has declined even as production has grown.

Each oil producer is betting that one of the others will crack first.Asin a war, every country and every company hangs on until they reach a crisis point.In a country, perhaps it will be a moment of social collapse. In the case of companies, it will be the final moment when company managers and their bankers just cannot justify continuing.

Hitting bottom

Unlikeeconomies ended by war or cities destroyed by fire, market capitulation isnot so extreme.

New York's Dow Jones index and the TSX weredown hundreds of points on Friday.No one seems quite sure when it will stop.The price of houses in Calgaryis looking for a bottom. So is the loonie, whichis dependent, at least partially, on the value of oil and copper, which depend on when China hits bottom.

In market lore, capitulation is a good thing. Companies have been forced by necessity to cut costs. Some have gone broke. Capitulation, if you can recognize it, iswhen all the bad news has been priced in and markets can begin to rise again.

In the wider globaleconomy,there may be problemsthat have not yet been solved that still requirethe pressure of necessityto force governments into unpalatable action.

No one wants to sell their house for less than they think it's worth. No one voluntarily asks for their buying power to shrink. No one wants to pay higher taxes. Sometimes itis only the cruelty of recessionsand capitulation that forces us to make painful change.

Follow Don on Twitter@don_pittis

More analysisby Don Pittis