The Bear’s Lair: Oil - the Sword of Damocles

Posted by Guessedworker on Monday, 23 October 2006 21:53.

Here is Martin’s latest offering at PrudentBear.com.  Subject matter: the highly political global oil economy, following on rather neatly from James’ antennae-twitching piece on hyper-inflation.


Since the recent drop in oil prices, the market appears convinced that we have seen the last of their stratospheric rise – the NYMEX oil futures contract remains under $70 per barrel for the next 2 years, for example. However the free market economists’ theory that supply will always arrive to meet demand increases is pretty shaky in the oil sector, and the market looks likely to be wrong.

In conventional analysis, the surge in demand from the emergence of India and China and a strong economy in the West is believed to be temporary.  Prices may be boosted by an unexpected event such as Hurricane Katrina or the Nigerian oil disturbances, but a sustained period of high prices such as in 2005-06 produces additional sources of oil supply. These take time to appear but eventually satisfy demand and drive prices down to their equilibrium level, currently thought to be in the $25-30 per barrel range.

This analysis may be wrong for a number of reasons.  On the demand side, this is not an ordinary economic boom, but has been “turbocharged” in China and India by the Internet’s one-off enabling of outsourcing to those two countries.  Thus the world’s economic growth is heavily concentrated in China and India, particularly China, rather than in the countries of the West and Japan in which oil demand is relatively saturated. 

The Chinese automobile market has grown from 3.2 million vehicles in 2002 to 7 million in 2006, and is now the second largest automobile market in the world, just ahead of Japan, 40% of the size of the U.S. market and 10% of the world market. Naturally the buyers of these vehicles are going to drive them, since gasoline remains a relatively small part of the overall purchase and maintenance cost of an automobile. Hence gasoline demand in China is rising not by the country’s 10% overall economic growth, let alone by the lesser figure that might be expected as usage becomes more efficient, but by something fairly close to the 22% per annum growth rate of Chinese automobile ownership. 

While Chinese gasoline usage still represents a modest share of world oil demand, if even a small part of the oil market is growing structurally by 22% per annum, the normal effect of higher prices in encouraging conservation and reducing consumption may be swamped. Indeed, that appears to be the case; in 2005 world oil demand increased by 1.2 million barrels per day, in spite of an average oil price around 40% higher than in 2004. Almost all that increase in demand was outside the OECD group of wealthy countries.

It may thus take considerably longer than is currently projected for high prices to suppress demand. Demand-pull pressure on supply is stronger than normal, and may be more sustained. The continuing emergence of China’s automobile culture may slow, but is still likely to become an ever-increasing factor in the world market for oil if only because of China’s enormous population.  India, too, is currently too poor to see a huge surge in automobile sales – about 1.4 million in 2006 – but there too sales are increasing by 20% per annum, a rate that must rapidly make the country a significant factor in the world oil market.

The supply side of the picture is also disquieting, because of politics. Traditionally, it has been supposed that new supplies of oil will be brought on stream as prices rise. Thus a doubling in world oil prices, such as we have seen since 2002, should bring a massive surge in supply that, together with increased conservation, matches and then surpasses demand, bringing prices tumbling down close to their traditional level, or a little above if the new supplies are more expensive.

It’s a nice theory, but it depends on oil producers behaving as economically rational operators, seeking to maximize long term profits.  In the 1973-82 oil price surge this was still true – just.  Much of the world’s oil supply was controlled by the major oil companies, who were indeed economically rational operators. In the Middle East, OPEC countries’ control over their oil supplies was still new, so there were considerable gaps in their technological capability if they had attempted to “go it alone.”  While the Soviet Union was theoretically committed to conflict with the West, it was both unsophisticated in the use of its oil resources to further that process and inefficient in its ability to turn the oil “tap” on and off.  The Middle East was mostly friendly to the West, with Iraq’s Saddam Hussein pursuing a moderate policy and only Iran taken over in 1979 by anti-Western forces.  The new (or greatly expanded) sources of supply in Britain, Norway and Mexico were both pro-Western and market-oriented.  Thus the oil price rise, while initially caused by political decisions in the Middle East, eventually proved unsustainable, although even then it was 12 years before oil prices fell back in 1985-86.

This time around, while everybody’s expecting the market to react as it did in the early 1980s, the reality is very different.  Of the major new sources of supply, only Canada, home of the Alberta tar sands, is pro-Western and market oriented.  The oil companies themselves are almost all short of supply, and have genuine control of only a modest part of the oil they produce. The United States is not taking the problem very seriously, so is allowing essentially trivial environmental objections to block drilling in the Arctic National Wildlife Refuge – that would be only a modest additional supply, but every little helps. Oil supplies in untraditional areas such as Africa will help to alleviate the supply/demand imbalance, but most new potential supply sources are of only modest size and many of them, in countries such as Angola and Nigeria, are in environments which while not politically hostile are very difficult places to do business.

However, the biggest change is the rise of oil producing countries which control their own supplies, have the necessary technology, but are motivated by political rather than economic considerations and are generally unfriendly to the West, especially to the United States.  However strong may be the economic forces pushing them to open new supplies (if they have them) these countries do not place economic wealth maximization as their first priority and are enjoying their new found power from expensive oil far too much to want to lose it again in a supply glut.

In ascending order of hostility to Western interests, apart from Canada, the major potential sources of new oil supplies are Saudi Arabia, Russia, Venezuela and Iran.

Saudi Arabia is the most potentially friendly of these countries, and has a big interest in keeping the Middle East quiescent and in preserving the United States as a potential bulwark against Islamist revolt. However, apart from the possibility of an Islamist revolt itself (currently fairly remote, but devastating to the world oil market if it happened) Saudi Arabia is also keen to avoid another 15-year period like 1985-2000, when the world ignored its political wishes, oil prices remained low and domestic unrest festered.  Further, since Saudi Arabia has not allowed an impartial outside audit of its oil reserves since the 1970s, it’s possible that its reserve production capacity is much lower than has been thought and its ability to increase output is in fact modest.

Russia was thought to be a major new protection for the West against Islamist problems in Saudi Arabia and the rest of the Middle East, and a major private-sector-oriented swing producer of oil which would keep price rises moderate. One can only laugh hollowly, and reflect on the folly of those such as George W. Bush who thought in 2001 that they had detected in Vladimir Putin a secret liberal reformer. In reality, the attempts by Moscow to deprive Shell of its property rights in the Sakhalin project are only the latest in a long series of control-seeking moves in the oil industry which began with the infamous arrest and imprisonment of Yukos chairman Mikhail Khodorkovsky.

The Putin government seems to be pushing Western oil interests and even the Russian private sector out of the oil business altogether, in order to use Russian oil production for strategic warfare against first Russia’s neighbors and then the West. Putin is infinitely more sophisticated than the old Soviet regime, and at least equally ruthless (Leonid Brezhnev is beginning to look like a teddy bear by comparison.) Low oil prices and secure supplies would wreck Russia’s leverage; Putin will do all he can to avoid them.

Venezuela is a smaller potential source of supply than Russia or Saudi Arabia, but it’s close to the United States, and in the hands of a friendly government its Orinoco tar sands would be an important new resource, probably viable at an oil price of $50-60 per barrel. Needless to say, it’s not currently in friendly hands.  What’s more, president Hugo Chavez has found a new friend in China, with whom Venezuela is to develop its new reserves, shipping 500,000 barrels per day round the world to the Chinese market, an economically idiotic but politically very astute move.  If oil prices drop, Chavez will probably be ousted.  There’s a modest chance he’ll be ousted even if they don’t drop, but only a modest chance, and while he’s there, Venezuela’s oil reserves will be used primarily as a strategic weapon against the United States.

Finally we have Iran, a country currently committed to anti-U.S. activity, and identified by Bush as a charter member of the “axis of evil”. When Bush made that speech, in 2002, Iran was pretty clearly no such thing; its moderate president Mohammed Khatami, in office since 1997 and re-elected in 2001, had indicated repeatedly that he wanted normalization of U.S.-Iranian relations.  What he got instead, from both the Clinton and Bush administrations, was the back of the hand; passage and renewal of the economically meaningless but politically offensive Iran-Libya Sanctions Act and identification as a cartoon villain. Little wonder that Iran pursued its nuclear ambitions wholeheartedly and that in a (rigged?) election in 2005 it rejected moderation and elected the extremist Mahmoud Ahmadinejad. 

In reality, Iran has the best chance of the antagonistic swing oil producers to remove its hostile government and choose the path of moderation and economic development, but it won’t do so without major policy changes by the West. (Of course, such policy changes might themselves encourage the Iranian extremists to nuclear adventurism, destroying Iran’s oil production as they did so – who said international relations were easy?)

Given the rapid growth in demand and the limited potential for near-term supply improvements, an oil price of $100 per barrel seems almost inevitable, probably within the next 24 months.  At some point, soaring oil prices, perhaps even as high as $200 per barrel, will produce a deep world recession, probably accompanied by surging inflation, which will temporarily solve the demand problem. Only then will the West have the opportunity to bring the situation back under control, by aggressively seeking new non-hostile sources of supply, while cajoling semi-hostile or openly hostile oil producers into regenerating the world economy,.  If that is done, the long term equilibrium oil price is probably in the $40-50 per barrel range, but getting to that point seems likely to take several very painful years.

In May 2004, when oil prices passed $40 per barrel, I wrote a light-hearted piece looking at the economic effect of $80 oil, while explaining that I thought it unlikely that oil prices would reach anything close to that level in the near future.  Three months ago, oil prices peaked only just short of $80.  That now looks far too conservative as a forecast of the oil price peak, and the relatively mild effects of that price look almost trivial compared to what we may have to face in the years ahead.

When contemplating the oil market, the Bear becomes even more Bearish than usual!


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ‘90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) - details can be found here.



Comments:


1

Posted by James Bowery on Wed, 25 Oct 2006 00:14 | #

It’s been apparent for many decades that the industrialization of Asia would put global strains upon natural resources.  This is why I became interested—duing the 1970s—in long-term solutions like solar power satellites constructed from lunar materials with supporting infrastructure.  No pollution from nuclear waste, CO2, sulphur or NOx’s, little pressure toward nuclear proliferation, an outlet for masculine energies other than war and quite possibly a profound psychological realignment from zero sum games such as race replacement with positive sum games within which men of European ancestry would clearly be valued highly by all people not to mention their own women.

Today this seems like a pipe-dream but mainly due to the catastrophic failure of the managerial/mercantile class to capitalize on the heritage of pioneering excellence in the US after the clear potential demostrated by the Apollo Program.

Now we pay the price of not deposing them all before they reduced the baby boomer generation to corporate concubines and eunuchs.


2

Posted by Wolfie on Tue, 31 Oct 2006 22:56 | #

I disagree with your assessment of Putin. He’s a nationalist who wants the best for Russia and I think he views the Russia of the past as too much of a push-over. He has a strong hand and he wants to play it; so I don’t blame him for that.

I don’t think he is a threat for Europeans, provided our politicians don’t give him the treatment GWB gave Iran.



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