The oil price rose Friday through $66 per barrel, up 60 percent since I wrote in June 2004 about the possibility of it hitting $80, and three times its historical average over the two decades 1982-2001. Yet the stock and bond markets over the last few weeks have shown only mild qualms, continuing their strong trend since April. So if $66 oil doesn’t matter, what price does? To what level must oil rise before the economy and stock market react as if they’ve been hit by a two by four?
In June 2004 I wrote of the possibility of oil hitting $80 per barrel, which seemed an unimaginably high number — after all, $40 per barrel, its price then, was already well above the highest nominal price the commodity had previously reached. I suggested that on the demand side Chinese and Indian consumption was likely to continue to increase, while on the supply side $80 per barrel was likely to prove a ceiling in the medium term, since at that price Canadian oil shale supplies would prove economically viable in large quantities. In the West, Europe was likely to see a sharp deflationary effect, while the United States would be less affected, except that high prices would cause a sudden fall in demand for housing located in the far outer suburbs.
Much of the above seems to have been fairly accurate. The deflation in Europe, particularly in the Eurozone, has surprised British and U.S. commentators, who had expected a stronger economic performance, and have ascribed it to the inherent inferiority of the European socio-economic model, the effects of high taxation, etc. In fact, the deflationary effect of high oil prices accounts for the difference between the Eurozone and Britain. In contrast to the position when Tony Blair came to power in 1997, British public spending as a percentage of GDP is close to the Eurozone average, and the economy’s level of regulation is also similar – hence there is no “political economy” reason for Britain’s relatively better performance. France, Germany and the major countries of the Eurozone are all major oil importers, while at the same time imposing such high taxes on petrol that a price rise has little effect on consumption. Hence a sharp rise in oil prices withdraws purchasing power from the Eurozone economy. Britain on the other hand is still nearly self-sufficient in oil; thus the deflationary effect of the oil price rise is much less.
Chinese and Indian demand for oil has continued to increase, albeit at a slightly slower rate than in 2004. Chinese demand in particular is beginning to run up against limited supplies; thus the abortive takeover bid by the China National Offshore Oil Corporation (CNOOC) for the second-tier U.S. oil company Unocal. This met with huge political opposition in the United States, including delaying legislation passed by the U.S. House of Representatives. It is now likely that China will turn to less benign ways of securing oil supplies, forming strategic relationships with oil-producing opponents of the United States such as Iran and Hugo Chavez’s Venezuela.
The result of CNOOC’s failure will be a less stable geo-political picture than if the bid for Unocal had been allowed to proceed, and an increased ability by anti-American demagogues in Iran, Venezuela and other oil producing countries to defy the United States. $66 oil inevitably gives oil producing countries greater strategic power, but without the assistance of a major military and geo-political force such as China they (with the notable exception of the oil producing nuclear power Russia) had no means of deploying that power. Now they have, and U.S. interests are likely to suffer thereby.
On the demand side, my forecast blundered in predicting a major effect on U.S. oil demand, including an appropriately apocalyptic vision of the outer suburbs being abandoned to squatters as commuters abandoned their new McMansions, from which they were unable to afford the costs of commuting.
All good bearish stuff, but in reality this forecast appears currently to have been completely out to lunch, even though we are still $14 short of the magic $80 figure. The U.S. housing boom continues at a record pace, with much of the action around big cities inevitably being concentrated at the outer edge of existing developments. Even consumption, which on all the evidence should have been badly affected by the giant sucking sound of money leaving U.S. consumers’ pockets, has hardly been affected. Only the U.S. payments deficit looms monstrously as evidence that $66 oil is having an effect, and that in spite of a tranquil surface the U.S. economy is indeed imbalanced by the huge cost of oil imports.
Calculations made at $30 or $40 a barrel that oil’s cost was a much smaller percentage of U.S. Gross Domestic Product than in 1980, so we should not worry much about the deflationary effect of a price rise, can be torn up at an oil price of $66 a barrel. Oil’s weight in U.S. GDP just doubled — however long it takes the Bureau of Economic Analysis to admit this. So where’s the deflationary effect?
It’s probably on the way. The U.S. economy has been hugely stimulated over the last decade by cheap money, and in 2004-05 this has produced a housing boom that has become self-sustaining. The stimulation has continued as the Federal Reserve has raised short term interest rates in tiny steps of ¼ percent per meeting, at a time when inflation has been gradually accelerating – it is thus likely that the first eight increases, to a 3 percent Federal Funds rate, had no effect on the economy, and only the last two increases, reducing the gap between short and long term rates below 1 percent, have begun to take the monetary foot off the accelerator. Tax reductions in 2001 and 2003, and a surge in government spending that has continued throughout the George W. Bush presidency have also been stimulating, at least in a short term Keynesian sense.
Oil prices only moved definitively above the $50 range in the last quarter. Hence their depressing effect on U.S. consumer spending, and on the economy as a whole, will only begin to take effect in the next few months – and in theory could be avoided altogether if prices were to drop back rapidly below $50. It is thus likely that oil’s drag on the U.S. economy will become apparent in the fourth quarter of 2005, as oil price increases combine with continued interest rate increases to send U.S. consumption, U.S. housing, the U.S. economy and the stock market into a definitive and prolonged downturn.
What probably won’t happen is the devastation of the outer suburbs. Even at $80 per barrel, gasoline in the United States would cost only a little over $3 a gallon, far cheaper than in Europe for the past quarter century. At $3 per gallon compared to $1.50, the additional cost of gasoline for a commute of 50 miles each way, say 5 gallons a day for an average car in semi-urban traffic, would be $37.50 a week, or $1,800 for a 48 week year. This will upset some marginal budgets, it is unlikely to change many purchase decisions on a $300,000 house whose mortgage cost is roughly $21,000 per annum. Only at $200 per barrel, giving a petrol price of perhaps $8 per gallon, would the additional cost of about $7,800 per annum become sufficient to devastate the outer suburbs, and that is currently unlikely.
The additional cost of gasoline at $80 per barrel may however make smaller cars once again fashionable, and severely affect the market for SUVs. The additional fuel cost for the long distance commuter of a 15 miles per gallon SUV compared to a 30 mpg midsize is $2,400 per annum, enough to affect most car buying decisions.
On the supply side, my optimism last year that Canadian oil shale would cap the rise in oil prices at around $80 per barrel is currently looking shaky, if only because $80 is a much closer target from $66 than it was from $40. In that calculation I had not considered the long term effect of secular increases in oil demand from China and India, which will put far more pressure on world oil supplies than we are used to. On the demand side, the calculation above suggests that conservation is likely to have only a modest effect at $80 per barrel, though it would certainly have a big effect if oil ever hit $200.
I would thus expect the long term average of oil prices to settle in the $70-90 range, with a steady upward trend (interrupted only by deep recessions) and short term spikes that might push well above that range. Canada, with its large supplies of $80 per barrel oil, becomes a very important strategic partner indeed for the United States, and protectionist lobbies that produce irritants over such trivia as Canadian lumber and Canadian beef imports should thus be slapped down. The somewhat “wimpy” Canadian view of an appropriate U.S. foreign policy also needs to be taken more into account.
With this outlook, it is clear that the recently signed $60 billion Energy Bill is a waste of money, money that will become scarce once the deflationary effect of the oil price rise hits the U.S. economy. Not only does the bill contain little for conservation, it does not even open up the Arctic National Wildlife Refuge for drilling, an egregious bit of cheap pandering to the environmental lobby that will cost the U.S. dear (getting Saudi quantities of oil out of Albertan shale is not going to be environmentally pristine, to put it mildly.) Meanwhile, agreements with Canada, to secure future supplies of oil for the United States, and China and India, to secure future supplies of oil for them without encouraging anti-American foreign policy meddling, are matters of the highest priority.
The oil price rise is serious already; we just don’t realize it yet.
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(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 the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. 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.)
This article originally appeared on United Press International.