With oil prices touching $42 a barrel on the New York Mercantile Exchange, many economic commentators have gone into denial, pointing out the many reasons why they can be expected to relapse again to the $30-35 range. Yet there is an alternative scenario, in which supply disruption causes oil prices to rise much further, and it’s worth looking at how such an event would play out.
Marginally the most probable scenario is still that oil prices will gradually subside, returning the oil sector of the economy to approximately its state over the last few years, with prices significantly higher than in the 1990s, but still well below the peaks reached in 1980-81. However a number of factors in the last few years have made oil market disruptions more likely. The spare capacity in world oil production, around 8 percent at the time of the first Gulf war in 1991, is now down to around 3 percent, since only Saudi Arabia has sufficient revenues and is sufficiently non-market oriented to maintain substantial spare production capacity.
China and India have been growing economically at a very rapid rate, to a level where their oil consumption becomes a significant factor on the world market. Since Chinese oil consumption increases more than proportionately to income growth (at this level of wealth, as Chinese consumers acquire cars in increasing numbers) oil consumption in China is rising very rapidly indeed, at close to 20 percent per annum..
Russian oil, thought to be a new safety valve for the world market, as a substantial source of supply relatively invulnerable to terrorist disruption and the problems of the Middle East, now looks much less certain. The arrest of Mikhail Khodorkovsky and the attempt by the Vladimir Putin regime to dismantle Yukos, control the remainder of the oil business directly, and raise substantial further taxes from the sector has disrupted foreign investment in the sector and rendered Russian oil company management risk averse, at a time when an entrepreneurial outlook would have reaped huge benefits.
Finally, the incidents of terrorist violence in Saudi Arabia, while they have so far not affected oil production directly, must raise the possibility that either a direct attack on Saudi Arabia’s oil installations, or, worse still, a successful fundamentalist assault on the Saudi Arabian government, could leave Saudi production decimated and the word oil market in a condition of severe shortage.
There is a limit to how high the oil price can go over any but the shortest term; at some point consumption is slashed and inventories drawn down, for the period until new production can be brought on stream. Currently, the most substantial “swing” capacity available is in Canada, where reserves approximately equal to 2/3 of Saudi Arabia’s are available in the form of tar sands, difficult and expensive to extract. In the early 1980s, it was reckoned that a price of $40 per barrel (about $90 today) was necessary before tar sands oil could be extracted. More recently, technology has improved, so there is now a modest project extracting oil from Alberta’s tar sands, which makes money at around a price of $30 per barrel. Of course, that calculation does not include the twenty years of investment and development necessary to get the project on stream, so that a sustained price significantly above current levels would be necessary before it was economic for tar sands oil production to be ramped up. Nevertheless, the availability of the reserves and the capability puts a cap on world oil prices, perhaps at around $80 per barrel, about $10 per barrel above the present day equivalent of the 1981 peak.
If oil were to reach $80 per barrel, it is by no means certain that a glut of production would be forthcoming, driving its price down once again to a third or a quarter of that level, as happened in 1982-1998. Both current production capacity and world oil reserves are significantly tighter than in the early 1980s. A 2003 study by the University of Uppsala, Sweden suggested that total world oil reserves were only around 3.5 trillion barrels, compared to estimates of between 5 trillion and 18 trillion by the Intergovernmental Panel on Climate Change. This is good news for those fearing global warming (if you haven’t got it, you can’t burn it) but would imply world oil production peaking around 2010, and a future price path much higher than we have seen in the past.
On the demand side, China’s rapid growth is likely to continue, no doubt with hiccups, and to be joined by equally rapid growth in India. The gradual advent of 2.4 billion new drivers to the world’s roads will put an upward pressure on oil prices that they have not seen in decades.
An oil price of $80 per barrel (in current dollars) is thus very possible, at least on a 5 year view. Such a price would have important economic consequences, not quite those forecast at the time of high oil prices in the early 1980s.
In Western Europe, the consequences would be fairly minor. Whereas a price of $80 per barrel implies a petrol price at the pump to U.S. consumers of about $4 per gallon, the price in Britain and most of Western Europe is already in the $7-8 per gallon range, most of it caused by tax, and so would rise only by the same $2, to $9-10 per gallon. The effects of the rise on consumers could be removed completely, by governments reducing their petrol taxes correspondingly. However, this would result in high and sustained budget deficits. Hence it’s likely that oil taxes would be maintained, producing a moderate reduction in consumption, a moderate increase in inflation (most of which would be one-shot) and a deflating effect on the economy as revenue was transferred from European consumers and their governments to Middle Eastern and other oil producers.
Europe would then be in the same boat as in the 1970s. The Middle Eastern oil producers would have a greater capacity to absorb the increased revenue than in the 1970s, but even so a great portion of the revenue would be saved by the rulers or the corrupt billionaire businessmen around them, or used to subsidize terrorist operations against the West. Thereby, the transfer of wealth would not be self-correcting, as the French economist Jean-Baptiste Say would have predicted, but instead would be economically deflationary, as in the 1970s, producing in Europe a moderate recession.
In the Middle East itself, judging by the 1970s, the effects of $80 oil would be almost wholly pernicious, because oil revenues are controlled by the corrupt local governments, and not by private companies or by the people as a whole. This was my principal reason for recommending in March 2003 that the United States remove control of Iraq’s oil revenues from the Iraqi government and set up an uncorrupt trust fund (maybe run by Singaporeans, who have such a trust fund domestically) that would take care of Iraqi health, education and old age security needs. This has not been done. In its absence, in Iraq and in other countries of the Middle East, as well as in Nigeria, Indonesia, Venezuela and Mexico, it is likely that the oil revenues will simply increase the wealth, power and corruption of the ruling elite, condemning those countries to perpetual underdevelopment and greatly increasing the danger to the West from insane armaments schemes and financial support for international terrorism.
In Russia, it could go either way. Prior to October 2003 I was reasonably confident that Khodorkovsky and the other Russian oil oligarchs would run their fiefdoms like Western businessmen, albeit devoting excessive resources to expensive supermodels and London soccer clubs. However, the reassertion of state control over the Russian oil sector is very bad news; it makes it more likely that Russia, no longer needing Western industrial know-how or foreign investment, will use its new wealth on arms buildup and foreign policy adventurism.
In India and China, it is likely that the increase in oil prices would have little effect. Of course, China’s balance of payments would be adversely affected, and the general world recession might itself affect Chinese growth prospects. However, if the increase to $80 per barrel were to happen in the near future, the deflationary effect on the Chinese economy might well be salutary, producing better balanced growth but not reducing the country’s long term growth prospects. Moreover, the Chinese lifestyle has not yet been adjusted to reflect the advent of widespread car ownership, while the main economic barrier to car ownership for the average Chinese citizen remains the cost of the car itself and not the cost of the petrol it uses (cars are mostly small and annual average mileage driven low.) Hence, while you can expect a slowing of the rate of Chinese car purchase, and of the lifestyle changes that car ownership represents, the overall trend towards greater car ownership and greater suburbanization of China would remain in place.
The United States is the interesting case, where the high oil price might cause real disruption. Here, the 1980s and 1990s have at the consumer level greatly increased the need for cars in the ever expanding suburbs. While urban transportation networks have not been expanded much, and the Interstate freeway network, built in 1955-70, has been allowed if anything to decay, the pressure of population has been sharply increased by legal and illegal immigration. In addition, interest rates have for the last decade been low in real terms, providing great encouragement to the home-building industry. The result has been suburban sprawl on a fantastic scale, with 20 and 30 mile commutes now commonplace, and retailing concentrated in “big box” superstores” in which a marginally lower price is expected to compensate for the distance you must drive to get there and the unpleasantness of the shopping experience once there.
With petrol at $4 per gallon, inflation in at least a temporary up-trend, and long term interest rates rising, these incentives will go into reverse. Home-building will collapse, with the exception of modest remodeling efforts in city centers and suburbs close to public transportation. Large ex-urban houses, with lengthy commutes, will become unattractive to the yuppies intended to live in them (who in any case will be worse off because of the recession.) Consequently many of them will be abandoned, as their former owners are unable either to sell them or to make the mortgage payments; presumably squatters will move in. Suburban office malls will also become extremely difficult to let. Los Angeles, the archetypal city for long suburban commutes, will suffer accordingly, although the availability of people and resources for Internet pornography, a highly fuel-efficient business, will provide at least a measure of economic support for the area.
Retailing will reverse its trend to big box superstores, as their economics will no longer pay — the modest discounts available will not pay for the cost of driving to them. However, instead of reverting to its traditional pattern, retailing will become increasingly focused on the Internet, with mail order buying not only for books and electronic equipment, but increasingly for food and household goods. With large ex-urban homes a drug on the market, consumers will become increasingly concentrated in apartments and near-suburban townhouses; retailing patterns will alter accordingly, with smaller sizes and higher value items becoming more in demand.
In transportation, hybrid fuel/electric cars will finally become economically viable, but will not solve the problems of cities that have spread too far, since their range is small and the need to refuel them daily will be inconvenient. On the other hand, systems of public/private transportation may appear, in which an electric car is driven a short distance to a freeway, and then hooked into a dedicated lane, in which power is provided to the car from the road. These will have the advantage over their alternative, small, light conventional automobiles, of being very much safer, as the freeway will control their speed and prevent accidents.
Air travel, already weakened by the threat of terrorism, will become once again an economic basket case. Since the price elasticity of leisure air travel is so great, the price increases necessitated by higher fuel costs will have a disproportionately depressing effect on the volume of leisure air travel. This will make airports pleasant, uncluttered places, but render complex multi-stop business trips by air impossible because of infrequent schedules.
These economic effects will be rendered worse by government, which of course will intervene with counterproductive regulation and controls, to solve problems that are basically insoluble, or to prop up industries such as airlines, aircraft manufacturers and real estate that have become burdened by huge over-capacity. With the temporary death of the “American dream” of an ever-expanding stock market, ever growing economy and ever larger automobiles, it is likely that the temptation to meddle will prove irresistible. Expect unhelpful controls, pointless subsidies and regulations with appalling unintended consequences, just as in the 1970s. Oh, and high taxes.
Not quite a dystopia, in other words, but a pretty grim prospect, except for the small group of urban intelligentsia who don’t drive, despise the suburban U.S. way of life, rejoice in regulating, and welcome government controls. Funny how change frequently ends up benefiting them!
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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.