Oil In 2012

Oil In 2012: $200 Or $50?

By Martin Hutchinson | 28 May 2008

CIBC World Markets analysts recently predicted that oil would sell for $200 a barrel in 2012, as oil supplies grow ever tighter relative to demand. That would imply a continued global boom for the next four years, which would bring inflation, perhaps validating CIBC’s prophesy as the dollar went the way of the 1923 Reichsmark. All the same, that’s not the way I’d bet; I think $50 is more likely. We are probably not quite at the end of this unprecedented oil and commodities bubble, but we are surely getting close.

To take the hyperinflationary possibility first: The St. Louis Federal Reserve has since 1991 calculated a monetary statistic "money of zero maturity" which is M2 minus small time deposits plus institutional money market funds. In the absence of M3 statistics, discontinued by the Federal Reserve in March 2006, St. Louis’s MZM is a decent measure of broad money supply. MZM increased by a moderate 9.18% in 2007. However in the three months to April 14 2008, it has increased at an astounding annual rate of 30.3% reflecting the massively expansionary monetary policy the Fed has followed since January.

If the Fed keeps up that rate of growth for the next 4½ years then since prices follow monetary growth, by the end of 2012 prices would have risen by about 236%. In other words to have the same real price as today’s $115, oil would sell for $386 per barrel. A price of $200 per barrel would then represent a moderate oil price, reflecting a decline in real oil prices to little more than half today’s level in real terms. Needless to say, if the US dollar had been alone in suffering this level of inflation, the euro would in 2012 be selling at over $5 and the yen would be running at $1 = 28 yen.

So how likely is this hyperinflationary scenario, and how likely is $200 oil without it?

The hyperinflationary scenario depends on the Fed continuing to increase money supply by around 31 percent per annum for the next 4 years. That’s not quite impossible. Consider a world in which Fed Chairman Ben Bernanke has little or no fear of inflation, but where house prices are an essential political measure of the Fed’s success. In that case, to prevent house prices from catastrophic decline, Bernanke might continue to indulge in stimulatory policies, lowering interest rates as far as practicable towards zero, buying essentially unlimited quantities of dodgy housing debt from the banking system, and assisting in bailouts of any banks that got into trouble.

A sloppy populist administration, were such to be elected in November, might ally with the Fed in devise a series of ever more expansionary "stimulus packages" while prevailing on the Fed to support the Treasury bond market to help it fund its trillion dollar deficits. It might assist the process by erecting trade barriers against Third World imports, which would be seen as taking away jobs; such barriers would restore few jobs but might well produce huge increases in import prices. The rest of the world would doubtless go into recession as the US withdrew partially from the world market, so oil and other commodity prices would decline in real terms, but the dollar prices of non-oil imports could be rising so rapidly that the overall price level continued to inflate.

Sound horribly plausible? I’m rather afraid it is. The 2008 campaign has shown that the quality of economic thought among both the US primary electorate and the political class has deteriorated markedly in the last decade, so that there are few barriers today to rampant protectionism, rising inflation and ever-increasing government spending. There are a few counterproductive policies of the 1930s through the 1970s that would probably be avoided today, but not many of them.

There are thus only two factors that may save us from 30% inflation and $200 oil by 2012: a revival of good sense by the Fed and the politicians (very unlikely) or a full scale revolt by dealers in the US Treasury bond market. The latter is not at all improbable; the government’s borrowing is increasing substantially, with the current year’s deficit heading towards $500 billion even before recession has properly taken hold, so bond markets are going to be asked to absorb a LOT of debt. At some point, even with the Bureau of Labor Statistics doing everything it can to massage inflation figures, bondholders and dealers will come to realize that they are being asked to buy Treasury bonds that yield less than zero in real terms [[they already do! : normxxx]]

A good healthy "buyers strike" would then push up Treasury bond yields, probably forcing Bernanke’s resignation (as it did the resignation of his predecessor G. William Miller in 1979) and force a tighter monetary and fiscal policy on the US powers that be. It is a consummation devoutly to be wished; one’s only doubt is that inflation has been rising steadily now for several years and yet Treasury bond yields remain stubbornly around their levels of 2004. Continued heavy buying by the less than stellar intellects of Middle Eastern and Asian cash rich central banks could prevent a catharsis that all should desire.

Assuming that we get a "buyers strike" in the Treasury bond market or (less likely) a revival of good sense in the Fed and Treasury, inflation is unlikely to soar to over 30% and thus oil is unlikely to trade around $200. In such an event, interest rates would be increased to begin the lengthy task of wringing inflationary forces out of the system. That would reduce the flood of liquidity in international markets, which would have two effects. First, it would reduce the rate of world growth, affecting particularly those countries such as India and Latin America whose fiscal ( India) or balance of payments (most of Latin America) position was already somewhat weak.

Second, it would greatly reduce the loan capital available to international speculators, which have been an increasingly important factor in rising oil, gold and commodity prices in the last year. There are reports that hedge funds have already been compelled to reduce their leverage to a maximum of five times capital. I would tend to be skeptical of such reports, but clearly if interest rates were forced upwards the arithmetic both for hedge funds and for those who lend to them would change radically.

That scenario, of slowing world growth, particularly in markets with heavy real estate exposure (such as the US, Britain, Spain and Ireland) or in over-leveraged emerging markets, would be devastating for commodities markets. Speculative demand would quickly be removed from them, partly because of the bankruptcy of the speculators, and real demand would also be somewhat reduced. Commodity prices would fall towards equilibrium levels.

In the case of soft commodities, the fall towards historic levels would be rapid. Production is already being ramped up because of current high prices, so it is likely that in 12 months time there will be a glut of most crops. The ethanol from corn politically-inspired disaster is registering even in the minds of US politicians, so even if the bizarre and counterproductive US subsidies for that process are not repealed, they will not be extended. World food consumption is increasing only relatively slowly, with some change in mix as wealthier Indians and Chinese eat more meat, so with a further slowing in consumption growth it will take very little time for production to catch up.

For gold and silver, the trend depends on the outlook for global inflation. If low interest rates are allowed to persist until inflation has got a real grip, it is likely that inflationary expectations will worsen, driving up gold and silver prices further. Even when interest rates are raised, confidence in government’s firmness against inflation will probably be slow to revive, so speculators and investors may continue to hold gold and silver as a hedge— after all, with rising interest rates stock and bond prices will be declining, so there won’t be an obvious alternative home for their money. Thus the equivalent 2012 prediction to $200 oil, $2,000 gold, may very well be possible, although it is likely that such a price will be seen only early in the year, with the overall trend by then, perhaps two years into the fight against inflation, being firmly downwards.

Finally, the oil price itself. Two factors have been driving the rise in oil prices. One, rising demand, has been discussed in relation to food and can be expected to follow the same pattern. As the world economy slows, demand will increase more slowly, while the speculators will be squeezed out of the market by higher interest rates. Nevertheless, absent changes on the supply side, one might still postulate 2012’s oil prices to be close to current levels.

It is on the supply side that a global recession makes the most difference. Here the continually rising price of oil over the last five years has awakened primitive nationalism in oil-producing countries, causing them to maltreat foreign oil companies and attempt to squeeze as much government revenue as possible out of the oil goose that is laying so many golden eggs. New oil discoveries are becoming more and more difficult, because in only a few countries are oil companies with modern exploration techniques given the right incentives to search aggressively for oil. Even Russia, the white hope for greater oil production five years ago, has seen its production begin to decline in 2008, while Mexico (closed oil sector), Venezuela (socialist fruitcake) and Nigeria (kleptomaniac government that taxes oil revenues at 98%) have all seen oil production decline by more than 10% since 2006.

There are a few counterexamples: Iraq’s oil reserves have doubled since that country was reopened to international exploration in 2003, while Brazil, whose Petrobras enters freely into joint venture agreements with Big Oil, has made major new oil discoveries recently. However, while oil prices continue to rise the search for new oil sources is likely to be restricted to only a limited number of geologically promising areas.

Once oil demand starts to tail off and interest rates rise, the current situation will reverse. Badly run countries such as Venezuela and Nigeria will quickly run out of money. Current policy will then be reversed, and the major oil companies will once again be allowed to explore and produce on an efficient and profitable basis.

Oil prices will then decline more rapidly, and wealthier and better run oil producers such as Russia and Saudi Arabia will also find themselves in difficulty, and become less recalcitrant in international politics and less resistant to help from the multinational oil companies. Slackening oil demand will also give time for new supply to come on stream, and for environmental objections to massive supply from tar sands and oil shale to be overcome. The result, as in 1981-86 will be a decline in oil prices, gradual at first but probably accelerating until a floor is reached at which new exploration becomes pointless and the oil price is once again as far below its long term marginal cost as it is today above it.

By 2012 that process will only have gone part way; nevertheless an oil price of $50 before the end of that year seems probable. Oil prices may well be on a long term upward trend, as supplies become restricted to geologically and politically more difficult areas, but $50 per barrel is already (absent hyperinflation) well above the real oil price in 1986-2002 and should easily prove sufficient to reward both efficient exploration and more intensive production from the tar sands of Orinoco and Athabasca.

Just as in stocks and housing, the price of oil cannot go up forever.


Oil Could Hit $200 In 'Super-Spike'

By Ambrose Evans-Pritchard, Telegraph.Co.Uk | 10 May 2008

Oil prices threaten to hit $200 a barrel in a final "super-spike" over coming months as producers fail to keep pace with blistering demand from China and the Middle East, according to a controversial report by Goldman Sachs. "We believe the current energy crisis may be coming to a head. A 'super-spike' end game may be in the early stages of playing out," said Arjun Murti, the bank's energy strategist. Goldman Sachs said a chronic lack of supply would lead to a "dramatic and continuous rise in oil prices", followed at some point by a sharp fall in oil demand as consumers retrench.

US crude prices hit a fresh high of $122.35 a barrel [9 May] as rebel attacks on Shell installations in Nigeria and tensions in northern Iraq continued to strain markets already caught in a crunch. Prices have doubled over the last year in what amounts to a massive transfer of wealth from the Atlantic region to the rising commodity powers. This week's jump in prices comes despite the partial recovery of the dollar against the euro, suggesting that alleged investor appetite for oil as a sort of "anti-dollar" is no longer driving the market— if it ever was. Prices have now surged by more than $50 a barrel since the credit crisis began.

The market has shrugged off the effects of a housing slump in the United States, Canada, Britain and Spain. The oil boom has revealed just how much the world has changed from the days when the OECD club of rich countries invariably dictated the oil price. Petrol prices in China and most Mid-East countries are held down by state controls, insulating demand from the effect of the global downturn. Between them, they account for the lion's share of extra oil use over the last two years. OECD consumption has been flat since 2004.

Goldman Sachs said the spare capacity of the OPEC cartel is already near "minimal" levels. There is a risk that Saudi Arabia will fail to meet output targets, suffering the same sorts of setbacks that have plagued Western oil companies. Non-OPEC producers have lurched from one disappointment to another. Russia's output fell 150,000 barrels per day in April compared to a year earlier, confirming warnings from industry leaders that Russia's oil infrastructure is woefully deficient.

"The possibility of $150-$200 per barrel seems increasingly likely over the next six to 24 months. A gradual rally in prices is likely to be longer-lasting than a sharp sudden spike," said Goldman Sachs. The bank recommended buying Chevron, ConocoPhillips (Conviction buy), the oil service group Halliburton and explorers such as Apache and Cabot Oil.

Not all analysts believe oil prices can defy the global economic slowdown for much longer. Citigroup said prices may fall to $40 a barrel within two years as the cycle turns in time-honoured fashion and fresh supply emerges. Lehman Brothers said this week that crude prices had surged far ahead of rise in the underlying cost structure of the industry— typically a warning sign at the end of a cycle. The drilling cost for oil and gas wells has actually fallen slightly over the last two years, and even deepwater rig rates have been flat after jumping five-fold since 2004. Some 65 deepwater rigs are coming on stream over the next two years, compared to 10 from 2002 to 2007.

"We believe the energy sector is about to see the explosion in the availability of rigs to explore and develop petroleum in deep waters," said Lehman Brothers, citing fields in the Atlantic Basin, the Gulf of Mexico, the northwest shelves off Alaska and Norway and new discoveries off the coast of Brazil. Data on futures contracts from America's CFTC show that speculative "short" positions on oil jumped 11% last week, suggesting that at least some hedge funds suspect the boom is overdone and ripe for a fall.

The picture is contradictory, however. Futures prices as far out as December 2016 have been rocketing to fresh highs, in some cases vaulting at an even faster rate than spot prices. This is unprecedented. "We think these moves are very important as they signify the extent to which medium and long-term perceptions are anchoring values," said Barclays Capital.

The bank said Gordon Brown and President George Bush were whistling in the wind by blaming OPEC for the latest price surge. The cartel no longer has the capacity to crank up production even if it wanted to do so, said the bank. The bloc's president, Chakib Khelil, said last month that there was very little that producers could do to stop oil reaching $200, if that is where the market wants to go.

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Normxxx    
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