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Is the Global Economy Drowning in a Sea of Black Gold?

by: Hiren Doshi July 20, 2008 | about stocks: DBE / DBO / EEM / EFA / OIL / SPY / USO    

Hiren Doshi

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The G8 summits were formed as a response to rising oil prices in the mid seventies. It was not until 2000 that the environment was included in the agenda. Serious discussion around it started only in 2005 when climate change was identified as one of the priorities of the summit in Scotland (albeit the outcome came quite short of expectations). At a climate change conference in Bali last December, all G8 countries except the US pledged to cut emissions by 25% to 40% from the 1990 levels by 2020.

On July 8, the G8 leaders agreed on a 'Document on Environment and Climate Change'. The leaders of the G8 agreed to share with the members of the UNFCCC the vision of achieving a goal of at least 50% reduction of global emissions by 2050. The G8 stated that achieving the ultimate objective of the UNFCCC will only be possible through common determination of all major economies. It was acknowledged that participation from China, India, Brazil, Mexico and South Africa is critical to a Climate deal that would take effect when the first phase of the Kyoto Protocol expires in 2012.

China and India flatly refused to the goals citing reasons that energy security and economic growth are equally important for developing countries and no climate change goals can be formulated in isolation. Their argument was the G8 countries are responsible for much of the emission that has pushed the world into major environmental catastrophe and they should do more to rectify the damage. Over 80% of the emissions in the atmosphere today have been caused by the G8. Although the G8 is home to only 13% of the global population, it emits more than 40% of global carbon dioxide. The US comprises around 4% of world population, constitutes 26% of world GDP and consumes 26% of global energy supply.

The increase in oil prices clearly affected this year’s discussion, playing a critical factor in the G8’s adoption of a climate declaration which the environmentalists have condemned as too lax and vague. The agreement reflected a consensus that any pronouncement on climate change has to take into consideration the state of the global economy and energy security concerns of developing nations.

Oil prices have increased by 1,400% in the last decade and have now reached a level that is threatening to drag global economy to a grinding halt. This era in effect has come to be the third oil shock that the world has seen since 1970. During the first oil shock, oil prices had almost quadrupled from $3.5pb to $13.5pb between 1973 and 1975. During the second oil shock, the price jumped by more than 100% from $15pb to $39pb. In the current phase, oil prices have increased from $55 a barrel since early 2007 to current levels of $130 a barrel.

The US and other developed countries attributes this rise in oil prices to the fact that the global oil supply by producing nations has not been able to keep pace with ever increasing demand from consuming nations, more so the emerging countries like India and China. The counter argument to that theory is that rather than fundamentals, massive amount of speculative activities is mainly responsible for the recent hike in not only oil price but also commodity prices across the board. If the later is true, the bubble has to burst some day and we will live to see oil price come down to sane levels. A closer look at data suggests that this might just be the case.

Michael Masters, a US-based hedge fund manager, suggested a month back to the distinguished members of the US senate committee on homeland security and governmental affairs that speculative demand is behind much of the recent rise in commodity prices and the US lawmakers must curb speculators’ access to commodities if commodity inflation has to be brought under control.

The same view was again emphasized in the recently concluded Jeddah conference of oil producers and consumers. King Abdullah stated in no uncertain terms that the speculators are clearly behind the sharp rise in the oil price, which is estimated to have contributed to up to 60% of the increase. The rest of OPEC's members echoed his view but this was in stark contrast to the argument put forth by the US and Germany that the inability of OPEC to increase the supply in response to the fundamental rise in demand for oil is the real cause for much of the recent spike in oil prices.

To refute that increasing the supply is not the real problem, Saudi Arabia’s oil minister emphasised that the oil production capacity can and will be raised to increase the supply from the current 9.7mbpd (million barrel per day) to nearly 15mbpd by the end of 2009. Also, according to the US EIA, global output this quarter should reach 86.2mbpd and in a couple of years, the total output is likely to accelerate again as new oil fields come into production.

The mainstream media continues to glorify the view that the world oil demand continues to be robust but in reality the world oil demand growth has been slowing over the last four years. The total consumption is expected to grow by only 0.3mbpd this year which will be easily absorbed by the new production coming into the system. Important to note is that the new supply is coming into the system at a time when the global economy is likely to slow down.

Amongst the major players shaping the new oil economy, China plays an important role on the demand side of the equation. China imported 145.2 million tons of crude oil in 2005 and imported 159.3 million tons in 2007. The figure for 2008 is estimated to be 170 million tons. The rising living standard led by newfound wealth in China (between 1996 and 2006, the number of private cars rose from 2.9 million to 23.3 million) and the rapid pace of industrialization has created an ever rising demand for oil for the foreseeable future. China overtook Japan as the world’s second largest crude oil importer in May this year. Japan’s crude oil imports in May rose 8% to 3.76mbpd which was surpassed by China who in turn imported 3.81mbpd. This surge in demand can also be temporary as Chinese tries to corner enough oil to avoid any disruption during the upcoming Olympics and ensure enough supplies for earthquake hit regions. In reality, the Chinese consumption of oil has actually decelerated in recent times. It is estimated by the EIA that Chinese oil consumption will only grow from 8 to 8.4mbpd from this to next year and this is well below its anticipated GDP growth rate.

At current prices the demand for oil, which we normally assumed to be inelastic, may well drop over the long run. Much of the inelasticity stems from the subsidies enjoyed by populations of many countries. However as governments starts aligning prices of oil to market levels, as recently being witnessed in Egypt, China, India, Indonesia, Malaysia, Taiwan and others, the demand will rationalize, consumption will fall and result in an increase of supplies as domestic oil companies capitalize on higher prices.

While the growth of emerging markets is cited as one of the key reason that oil prices will continue to rise in future, ignored is the fact that many countries are witnessing aging populations and many countries will see zero or negative population growth for many years to come. For instance, of the top 15 oil consuming nations, 10 of them will see negative or zero population growth for the next decade. This will severely restrict any significant increase in overall oil consumption.

If the fundamental supply/demand situation is only partly responsible for the astronomical rise in the current oil price, can speculators be the real culprits? One technical symptom which confirms this view is the increasing anomaly between the spot and future prices of crude oil. There seems to be more demand for paper oil than physical oil at current prices. This combined with the fact that crude oil inventory levels in the US are at their highest levels in a decade challenges the myth that oil is in short supply.

Most of the recent speculative activity in commodity prices in the US is being channelled through a relatively unregulated mechanism. Energy futures, which were earlier traded through exchanges such as New York Mercantile Exchange regulated by The Commodity Futures Trading Commission [CFTC] are now traded on the OTC electronic market. They were removed from jurisdiction of the CFTC in 2000. As of the end of last year, the total outstanding contract value on the OTC commodity exchange stood at $9 trillion, up by $1.9 trillion over the previous year. Assuming oil constitutes around 70% of the contracts, the new money being poured into oil contract would be $1.33 trillion. This amount is large enough to justify the theory that speculation could be behind up to 60% of the increase in oil prices in the last 12 months.

Speculation or fundamentals, make no mistake – the days of cheap energy have come to an end. The age of oil led to rapid industrialization and enormous wealth creation. It created the opportunity to harness technology, to drive productivity and output which has transformed the world over many cycles. It gave wings to globalization making the world a smaller place for manufacturing and distribution of goods and services. The very success and scale of this process has resulted in increasing the demand and thereby the price of oil, coal and natural gas.

Current energy price levels can threaten to alter the equation of capital, labor and energy. For instance, the US imports around 12mbpd and at $130 a barrel, it now constitutes around 4% of the US GDP, up from 2% of GDP a year back. This has essentially wiped out the productivity gain of an entire year in the US economy. The oil price rise from around $53 a barrel at the beginning of 2007 to current levels has come with a tax of $2,600 billion annually to the customers. Around two thirds of this transfer is from oil importing to oil producing countries.

Recent history has been defined by rapid technological innovation on back of cheap and abundant energy. Hopefully the same forces will prevent the energy price from devastating major structural pillars of the modern global economy.

Disclosure: None

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This article has 18 comments:

  •  
    Jul 20 04:37 PM
    Oil goes up $11 in one day, later drops $15 in 3 days, and that's based on supply and demand? I don't think so.
    Reply
  •  
    Jul 20 06:54 PM
    Michael Masters was exposed as 'talking his own book' in his testimony, in a recent Donald Coxe BMO report. His hedge fund is packed full of puts on shares like GM that would rocket in the face of a sustained oil decline - hence his testimony against speculators in front of congress, trying to initiate that same decline.
    It was political theatre I'm afraid, ironically staged by a massive speculator himself.
    Reply
  •  
    Jul 20 06:55 PM
    i have read with amusement the idiotic view put forth by many that speculation has nothing to do with the price of oil...it's all world supply and demand and the next stop in this insatiable thirst would be $200/bbl. there are many reasons for this price run and underlying world demand is about 4th down on the list.

    as for the "era of cheap energy" being over, i think i'd wait to see the effects of the next world wide recession before making such a stark judgment. i wouldn't bet the house on it.

    Reply
  •  
    Jul 20 07:18 PM
    icandoitdon

    Instead you are betting your house, your car, your way of life on the notion that there is an endless supply of cheap energy. If you really want to see an "idiotic view" you only have to look in the mirror.
    Reply
  •  
    Jul 20 09:27 PM
    Please remind me, what state is Bush from ?
    Reply
  •  
    Jul 20 10:08 PM
    beans:
    There is a supply of cheap energy which has nearly zero emissions... it's called Nuclear. However, until the hippies get over some shit house Soviet reactor that by their own admission was a pile of crap that melted nearly 30 years ago, this useless debate on fossils will continue.
    A) Bring on Nuclear power (ala France)
    B) Bring on the high power, electric car
    Reply
  •  
    Jul 20 11:44 PM
    Oil prices will only climb, oil prices dropping as much as being said is the biggest fairy tale of all
    Reply
  •  
    Jul 21 05:50 AM
    @DimSum: the problem witzh nuclear is not 'some crap soviet reactor'. the problem is disposal of the radiating waste. this highly toxic and radiating stuff cneeds to be stored for the next 10,000 years - safely!
    Apart from the costs of that (any talk of 'cheap' nuclear energy, therefore, is a complete joke), man has not been able to find a safe place and to construct a material that would last for more than 200 years. Not to speak of 10k!!
    Nuclear is the biggest idiocy of them all - there are reasons why germany has opted to abandon(!) it and why Austria built a plant 15 years ago - but the people voted overwhelmingly to never run it!
    Reply
  •  
    Jul 21 06:52 AM
    Dim Sum---You are totally right. Most muclear waste will be reused and the small amount left can be easily stored. Nuclear power is the only power that can replace oil and gas. Its clean, safe and produces no CO2.

    07--Forget the Germans and Austrians --two cultures who will spend the next thousand years under their bed.
    Reply
  •  
    Jul 21 07:01 AM
    When the price goes up it's SSDD, that has been in the news for years. It's definitely speculation that ran this up. I'm short oil since last Tuesday and doing very well.
    Reply
  •  
    Jul 21 07:12 AM
    The author seems to say US crude inventories are the highest they have been in the last decade. I check the EIA site (www.eia.doe.gov/pub/oi...) and they seem to say crude inventories are at the bottom of the range for this time of year ...
    Reply
  •  
    Jul 21 08:46 AM
    Government satistics are unreliable. Any government that would change the way it counts traffic fatalities to justify the 55mph speed limit in the 70's would manipulate satistics for fun or profit.
    See Mark Twain's comments on satistics.
    Reply
  •  
    Jul 21 09:41 AM
    Speculation needs to end. Just look at Bear Sterns. They had $18 billion in liquidity and it was all lost due to speculation and rumors. It's a sad state of affairs when so few can make so much profit from the sweat of so many.
    Reply
  •  
    Jul 21 04:21 PM
    Hey Bigtime, GM is the bargain basement investment opportunity most of us wait a lifetime for. The GM Volt, ever hear of it?
    Reply
  •  
    Jul 21 09:40 PM
    fxtrader07: Even if what you say is true about Germany and Austria I couldn't care less about their 1970's backward thinking. Look at France. 36% of power is sourced from Nuclear. Number of incidents to-date, 0. Quality of Air in France? best in world. Cost of power? Cheapest in Europe.
    As for waste, I'm pretty sure steel and concrete will last far more than 200 years. And the 30t per average reactor is far better than 1000's of tonnes from coal and oil emissions from an equiv traditional plant.
    Also I think you're forgetting the point of Nuclear, to cut emissions to improve the quality of the planet. Jury is still out on global warming however.
    Reply
  •  
    Jul 22 12:45 AM
    beans......

    i've been investing since you were a gleam in your daddy's eye and i've heard and seen it all including the idiotic notion that "this time it's different." gold bugs thought gold was going to the moon in the 1980s until it crashed and flatlined for about 20 years. same with silver. same with tech stocks in the 90s. same with real estate for about the last 20 years. and yes, the same with oil, which boomed in the 70s into the 80s before crashing hard.

    there are only 3 constants in the markets...fear, greed and amatuers who buy into the notion that "this time it's different."
    Reply
  •  
    Jul 22 10:43 PM
    The nuclear waste disposal argument is only really trotted out by those who don't understand it or are pushing radical environmental causes. Using Chernobyl as an example of how unsafe nuclear power is only holds up if all reactors are built without an outer shield, which none of the Western reactors are. It takes socialism to achieve that sort of environmental hazard.

    You could hold your entire family's lifetime of nuclear waste in the palm of your hand. The USA's entire nuclear waste since the 1950s would fit in a football field to a depth of only about 4 feet. All that needs to be done is find an agreeable site and stick it in there.

    With increasingly safe nuclear technologies becoming available it is really the only way forward.
    Reply
  •  
    Aug 04 11:00 AM
    I predict that political pressure will force Democrat's to compromise on drilling. Not because it is sound idea, but because Republican's have created a wedge issue that cannot be explained away in a 60 second thought-ending commercial.
    People are understandably afraid of the economy and feel the pain every time they they fill up. Most American's are in a "do everything" we can frame of mind. Drilling more oil, at first blush, appears to be a common-sense idea.
    The main thing people want is lower gas prices quickly. The US is such a bit player in world-oil production that we cannot impact the price of oil if we drill everything we might find. I did not think McCain would take the lower road, but now that Rove proteges are running his campaign, the lie that we can lower price by more drilling is supported by the majority of voters.
    You might make a better argument that we could marginally improve our supply potential at some point 10 -15 years in the future - but that is not as sexy as low gas prices.

    Prices are coming down for a variety of reasons driven by oil - investors : The biggest being the probability that the US demand for oil will continue it's downward trend as our economy slows down. Speculator's actually cause more oil to be held above ground in developed countries, and that also is driving the recent price decline.
    US consumption for gas declined 2.4% the last month measured - a huge number caused by many being forced to drive less.

    The quickest and most effective thing we can do to lower the price of oil is to change our consumption on US roadways - where 1 out of every 7 barrels of oil consumed in the world take place.

    If you listen to the CEO's of big oil, they will tell you that they sit on many oil leases and do nothing because the the cost of oil has been too low to justify the costly risks of trying to produce. They need stable, high prices to take on projects in the global economy. With the exception of Saudi Arabia, OPEC has done nothing to increase production because they could simply sit back and watch prices rise.
    If US companies are granted new leases, and we subsidize them enough so they actually move forward, OPEC may just cut their production to maintain price stability.

    In the short term, OPEC may finally increase their production to prevent further erosion of demand and development of alternate sources. LIke in the 70's, a lot of the demand decline today represents "demand destruction" - it is not sure term and will not come back as people abandon SUV's, drive less , hopefully drive more intelligently, and new better technology rolls out very soon.
    If our huge demand slows down more quickly than anticipated emerging market growth, OPEC may increase their production and hope the US stays the world's biggest waster of global oil.
    Reply
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