Who Is Afraid Of $50 Oil?
By Peter Zeihan
For the first time in history, oil prices on the New York Mercantile Exchange breached the $50 a barrel barrier on the back of the threat of supply disruptions in Nigeria, a new expatriate assassination in Saudi Arabia and leftover damage from Hurricane Ivan.
At $50 a barrel, prices are not simply strong, they are nearing historical highs in inflation-indexed terms. They have already breached the inflation-index highs of the 1990-1991 Kuwait crisis and the 1973 oil embargo. The only major watermark that remains unbeaten is the 1979 spike from the Iranian revolution.
The high prices also have staying power. Despite the fact that the autumn months are typically those of lowest demand, a wide range of geopolitical factors is keeping prices strong. Militancy in Nigeria, government intervention in Russia, sabotage in Iraq, incompetence in Venezuela, attacks against Westerners in Saudi Arabia and increasing international shrillness over the Iranian nuclear program are contributing to a very tense international environment. Hurricane Ivan also has gutted U.S. production and inventories during the time of the year inventories are normally building in anticipation of the high-demand winter months.
The current mix of geopolitical risk factors has at times added as much as $15 to the cost of a barrel of crude, but market fundamentals are strong as well. Even if the entire world were to go on Prozac for a few weeks, robust demand and strained supply would likely keep oil prices well above $30 a barrel for the next several months.
There are few developments in the market that might lead to a cooling. No producer is capable of bringing additional production online without first building capacity, and the easy work in that regard already is finished in Angola, Iraq and Russia -- the three states that accounted for most of the recent increases in global production. In all cases, additional volumes will first require high-dollar, long-term investments. For example, Russia first needs to expand its export network, which will require multibillion dollar pipeline projects and navigating the morass of the Russian political system. Saudi Arabia claims it still has 1 million barrels per day (bpd) in spare capacity, but the ability of Riyadh to bring it on line -- and the actual existence of that spare capacity -- remains shrouded in doubt.
Regardless, as autumn cools into winter in the northern hemisphere, global demand will once again surge, and all of Saudi Arabia's "spare" production would be sucked up to the last drop by burgeoning demand. The International Energy Agency estimates that demand will bump up 3.2 percent this year to a global record of 82 million bpd; Chinese demand alone is expected to surge 15.3 percent to 6.36 million bpd, while U.S. demand will edge up 1.9 percent to 20.41 million bpd. The International Monetary Fund (IMF) expects global gross domestic product (GDP) growth to hit 5 percent in 2004 -- the strongest showing in some 30 years.
Despite this sustained -- for now at least -- rise in oil prices, oil simply is not as important to most oil-consuming countries as it used to be. During the first major oil shock in 1973, total oil purchases accounted for some 8 percent of global GDP. In 2004, despite global demand having almost doubled since 1970, oil sales now account for only about 2 percent of global GDP. As technologies develop and spread and the information revolution takes root and expands, the amount of oil needed per unit of economic output continues to shrink. In the United States, for example, creeping (and often purely coincidental) moves toward fuel efficiency across the economy have more than doubled economic output in terms of oil input. This is a trend repeated the world over.
But oil is still nearing historic highs: $50 oil is still $50 oil. Every one of the past five major global recessions counted energy crunches as contributing factors. Oil might not be as important as it was 30-odd years ago, but to call it unimportant is simply silly.
So the question becomes: Who is afraid of $50 oil? The IMF estimates that should prices hold at $8 a barrel higher than their 2003 level of $25 a barrel -- which at this point assumes that prices plummet $18 a barrel immediately and hold there until year's end -- global growth will taper off by a mere 0.5 percentage points.
Were that growth reduction to be evenly spread across the global economy, this would be little more than a minor blip. But it is not. Countries that depend on exports to drive their economies forward in terms of GDP generated are more dependent on transport, and fossil fuels remain the primary driver of the transport industry. Poorer states almost always use less fuel-efficient technologies because they cannot afford the latest advances, as do countries that produce much of their own energy because they do not need to import it in the first place.
In terms of oil efficiency, those at the bottom of the scale are almost exclusively major oil exporters and Asian economies. Oil exporters will certainly have problems keeping their predominately poor populations happy while local fuel costs skyrocket, but ultimately they also are raking in cash from bloated oil revenues.
Not so for the industrializing states of East Asia, where the brunt of the impact will be felt. At particular risk are the states at the lower end of the income scale with the highest proportion of energy imports, such as Thailandand the Philippines. The (non-dollar pegged) currencies of all the Asian economies have suffered in the past few weeks.
This does not mean the United States and Europe will remain unaffected. Higher prices gut purchasing power and curtail economic growth directly and across the board. But the greater effect will be felt in Europe, not the United States. As U.S. interest rates rise -- and European rates hold steady -- the U.S. dollar is posed for a steady increase. Like the 0.5 percent reduction in global growth, this is also a "so what?" number until it is put into context.
All oil the world over is purchased and sold in U.S. dollars. So, while in dollar terms oil has more than doubled in price in the past 30 months and is reaching for historical highs, the relatively weak dollar means that in euro terms it has increased by only about 50 percent. That leaves oil prices well below the levels that sparked price protests across Europe in the summer of 2000.
With U.S. interest rates closing the gap and likely passing up European rates somewhere around the end of 2004, suddenly the high-growth, high-return U.S. market will appear far more appealing to investors than the mediocre-return European markets, where growth has lagged since as far back as 1991. The widening breach will drive the dollar up, the euro down and European energy prices through the roof. Even assuming oil prices do not rise further, a 20 percent rise in the value of the dollar -- well within historical precedent -- would slam Europe with a repeat of 2000 energy prices which presaged the Continent's 2001 recession.
Such recessions, whether they be in Europe -- or more likely, Asia -- are what will ultimately bring about the demise of this period of high prices. Crashing economies use less energy, and as demand falls, so do prices. But do not expect rapid relief. American interest rates might be on the upward march, but at their current 1.75 percent they still are within spitting distance of historical lows. So long as the U.S. dollar is the dominant global currency, U.S. rates will largely determine how easy it is for firms and countries alike to get access to credit; it has only rarely been easier. That will extend the ability of states -- poor and rich alike -- to purchase crude oil, no matter the price.
This, of course, lays the groundwork for the next international economic spasm. Cheap interest rates and expensive oil means lot of purchasing now and paying later. The next chapter in the story evolving from today's expensive oil is not so much the current geopolitical risk making oil so dear, but the debt hangover that importers will suffer when the recessions begin, rates rise and all those oil bills come due.
