PRICE SIGNALS OR CHEAP OIL NOISE?
Andrew McKillop
Founder member, Asian Chapter, Internatl Assocn of Energy Economists
Former Expert-Policy and programming, Divn A-Policy, DGXVII-Energy, European Commission
Oil prices and economic growth
The US economy attained it highest-ever postwar growth of real GDP, achieving what today would be the unthinkable and impossible rate of 7.5%, in the Reagan re-election year of 1984. At the time, in dollars of 2003 corrected for inflation and purchasing power parity, the oil price range for daily traded volume crudes was $57-$65/barrel. Despite this simple fact of economic history, Cheap Oil is still regarded by uninformed, sectarian opinion as a passport to economic growth.
Media and political comment would have us believe that regime change in the Mid East, initially in Iraq, will in time 'free up' and produce abundant supplies, but for the moment there is little avail and remedy on the supply side to immediately force down oil prices. Higher and much less volatile oil and energy prices underlying serious and committed energy conservation, transition to renewable energy and restructuring for a low energy economy, habitat and society are the real long-term solutions but these are discarded or rejected as utopian and unworkable by political decision makers. While claims are ritually made of today's economy being 'less oil dependent than in the 1970s' actual oil consumption, and oil import dependence as a percentage of consumption in a large number of OECD economies has risen by 25% to 50% since 1990 and continues to rise. Oil prices, given benign neglect when they fall, and energetic propaganda treatment when they rise have only one 'bottom line' in economic policy: the lowest price is always the best.
In theory the 'price signal' of higher oil and energy prices must be present if a range of goals stretching from reduced greenhouse gas emissions through energy independence to slowing the rate of fossil energy resource depletion are regarded seriously. If they are not, or they are denied as being of any importance this well explains the basic unpreparedness of large oil and gas consumer countries to accept higher and more stable oil prices. Any large interruption in supplies, of more than 5% or so for under 6 months, or depletion linked failure of world production capacity to match demand and its growth would, as in the past, create an immediate crisis.
This leaves 'demand destruction' as the sole option and real response to any large rise in oil or gas prices, through economy destruction by the interest rate weapon. The last time this was done, in 1980-83, oil prices were surely reduced through cutting economic activity in general. Oil prices in today's dollars fell from $100/barrel in late 1979 to around $60/barrel in 1984, but the collateral economic and social damage was awesome. Unlike today, however, the OECD economy started from a position of growth, with balanced budgets in many countries including the USA, in 1979-80. The world economy could and did take the horse medecine of sky-high interest rates without imploding into a sequence like that of 1929-31, but there is no certainty or guarantee this would be the case today - no 'soft landing' is currently on offer.
Oil prices as high as $60/barrel would not harm the world economy, in fact they would entrain increased growth at the 'composite' world economy level within a few months, but extreme interest rates, today, would result in massive economic damage. There would be certain collapse of world stock markets, runaway 'domino effect' bankruptcy of many major finance sector corporations, mass layoffs and unemployment, and grave problems for financing the structural trade deficits of especially the US and UK. The US, also facing an all-time record deficit of its public finances ($455 Bn in 2003) and around $4 Bn per month costs from its 'regime changing' experiment in Iraq would expose itself to the risk of runaway flight from the dollar as the interest rate weapon produced stock market and economic rout in its wake. The declining petromoney status of the GB pound would unlikely shield the UK economy from the sequels of the interest rate weapon being used as a blunt tool of energy policy, to force down oil demand. All European Union countries, and Japan would also face severe national budget financing difficulties, as tax revenues collapsed and spending to limit economic damage, including unemployment compensation and bailouts for large companies spiraled up as the crisis deepened. Financing increased state spending through borrowing would then lock on the upward spiral in interest rates, and itself intensify recession while maintaining inflationary pressures.
Why oil prices can only increase
For a number of reasons oil prices are on an erratic but upward trend since their 1998/99 most recent low of around $10/barrel. The most recent 'price shock' sequence can be described from various perspectives, including the following/
"It is useful to distinguish short-term price fluctuations from episodic movements that sometime characterise certain longer periods of time. The most dramatic episode occurred fairly recently and is still very alive in people's minds: this is the 1998/ early 1999 price collapse followed by rises which took prices to high levels throughout 2000. The WTI price (NYMEX first month futures contract) was at $17.65 per barrel at the beginning of January 1998. It reached a low of $10.80 in late December 1998, but the lowest levels were not hit until early February 1999 when WTI bottomed at $10.26 and Brent at $9.70. After that date the price movement was relentlessly upward with the WTI price ending the year at around $26.50 per barrel and peaking at $34.15 on 7 March 2000. It took 13 months of toil for the market to bring the price down by slightly less than $7.0 (that is by 39%) and then another 13 months of over-excitement to raise it by almost $24.0 (that is by 233%)". 'Does Oil Price Volatility Matter?", Robert Mabro, Oxford Energy - OIES Monthly Comment, June 2001
Amusingly enough Mabro and other commentators who characterise price increases as 'over-excitement', and price falls as 'toil for the market', trace the signal for this upward price movement to a late-1997 decision by OPEC to raise output quotas by 10%. This in turn isolates a key element of oil market mythology - the fixed belief that OPEC has always got spare capacity, and will always have spare capacity. For OPEC as currently constituted (including Iraq), and for the next 3 - 5 years no sane analyst can go above 31 - 32 Million barrels/day (Mbd) of exportable capacity, over and above domestic economy oil consumption needs. Speculation on this export capacity number is of course a prime subject of 'OPEC watching', but many unbiased observers suggest the real maximum export capacity of OPEC today, and for the next 3 - 5 years will have real difficulty exceeding 28 - 30 Mbd. More important, and with very few but key exceptions, exportable surpluses of current OPEC producers can only stagnate or diminish. The 'key exceptions' of course include Saudi Arabia and Iraq (with perhaps Abu Dhabi, Kuwait and possibly Nigeria) in the OPEC group, and essentially the Russian Federation alone in the nonOPEC group of oil producers with large exportable surpluses that can, could or might be increased.
Oil market price setting as Mabro and other commentators point out is through trading expectations, not facts. These expectations, in other words market mythology has it that there can only be slow, gradual and predictable rises in world oil demand, with supply from OPEC and nonOPEC 'players' always tending to increase above market demand. By consequence, prices 'spike' from time to time, when demand very temporarily outstrips supply, but always return to very opaquely defined 'normal trading levels'. For about 13 years through 1986-99 these were set at 'around $18-per-barrel'. Quite how this price was first arrived at and then fixed is at least as opaque and mysterious as oil prices attaining $100/barrel in dollars of 2003 during the Iranian Revolution, in 1979-80, but may relate to very cheap natural gas prices, operating a downward ratchet effect on oil prices. Cheap oil price theory embodied in the lucubrations of M A Adelman - that the 'right price' for oil is $2.50-per-barrel in dollars of 1972 - has like Gresham's Law fully displaced any consideration of why prices should rise, on the theory side. For a few weeks in late 1998/early 1999 the 'right price' of Adelman was achieved, when prices in current dollars hovered around $10/bbl.
We can suggest this supply-led, market mythologized pricing process that is defended by its admirers as 'real world application of Say's Law' is certainly no better than fixed or 'fiat' oil exporter price setting as used before 1987, and has not so many more glorious days of trading before it. In support of this, opening a chasm in cheap oil and cheap energy mythology we can note the special case of US natural gas market since late 2002. The US gas market and its price setting context is now exposed to a wealth of disinformation seeking to hide the essential fact of depletion, the simple fact that the US is 'drilled out' and is a harbinger and outrider for a depletion triggered shift to deficit overhangs on natural gas markets in Europe, and the world. Where gas pipelines cannot be constructed - through cost, geopolitical or time constraints - supply to compensate localized depletion will have increasingly to switch to LNG from exotic locations. Prices for this lifeline gas will also be exotic relative to $2/million BTU for gas and the $18-per-barrel oil that, in economic mythology, underpinned or perhaps flowed from the 'economic success' epitomized by the Clinton Boom of 1992-2000. None other than the absolute defender of free market pricing, Alan Greenspan, has let it be known that US natural gas prices may attain $7/million BTU, equivalent to $41-per-barrel oil, this winter. Greenspan of course did not add the simple fact that overcheap gas for too many years inevitably 'over downsized' gas exploration, proving and development effort, while encouraging consumers, including almost all new electric power producers in the US and many other countries to use cheap gas without a thought for tomorrow.
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