Oil and the Global Economy in 2006 and Beyond: Oil at $100 and Return to Stagflation?
Created: Oct 02 2005
I recently made a presentation for a leading European oil company on the implications of high oil prices for the global economy. Several questions were asked:
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Why hasn't the latest oil shock been associated with stagflation?
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Will global economic growth sharply slow down in 2006?
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Will oil prices further increase over the next few years and reach $100 per barrel?
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What are the likely scenarios for US and global growth in 2006 and what will oil prices be in such scenario?
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Will global rebalancing of large current account imbalances be orderly or disorderly?
The answers I gave are not in a formal paper but rather a lengthy powerpoint presentation (that is available here for RGE subscribers). Here are some of the summary points:
* Unlike previous spikes in the price of oil (1973, 1979, 1990, 2000), the latest one has not been associated with a US and global recession.
* Also, no stagflation (recession and high inflation) this time around.
* Why? Because this time:
1. more of a demand shock than a supply;
2. low actual and expected inflation to begin with given recent history of credible anti-inflation monetary policies;
3. oil importers have reacted as if the shock is temporary and decided to borrow to finance it;
4. recycling of "petrodollar savings" has kept long term interest rates low stimulating demand in oil importers;
5. little effect so far on consumer confidence and business confidence, profitability and productivity.
* But the recent oil shock has several supply side elements:
1. "Katrita" is a serious supply shock
2. Fear premium from terrorism and geopolitics
3. Low investment in upstream (exploration/production) and downstream capacity (refinery) in last few years
4. Global capacity is very tight
5. Geo-strategic risks in several producer countries (Iraq, Iran, Saudi Arabia, Russia, Indonesia, Venezuela, Nigeria, etc.). Such countries are under-investing in oil exploration and production.
6. Stress point in the latest "hog cycle" of oil prices
7. Potential transition to peak oil in the next few years
8. Medium term (btw 2005 and 2010) clash between rising demand and limited supply capacity leading oil prices to go above $100 a barrel.
* The oil price is likely reach $100 a barrel in the next 3 years. Why? As pointed in my previous blog:
1. Global demand for oil is growing at about 2.1% per year or about 2 mmb/d (million barrels a day) per year. So, new net supply has to increase by as much just to maintain prices at current high levels.
2. But since existing production fields get depleted at the rate of over 4 mmb/d per year, new production from new oil fields has to be at least 6 mmb/d per year just to ensure that the additional net demand is satisfied.
3. So, where will the new 6 mmb/d per year new production come from? Serious geo-strategic risks to supply in all the major producers (Iraq, Iran, Saudi Arabia, Russia, Nigeria, Venezuela, etc.)
4. We would already be lucky if two thirds of this new production per year is available between now and 2010.
5. Thus, based on standard elasticities of demand for oil in face of a highly inelastic medium term supply, this implies that we will oil at $100 per barrel well before the end of this decade.
6. Of course, a US and global recession would be triggered by such a supply-based spike in the price of oil. Then, this recession would push oil and commodity prices down as demand sharply contracts in the recession.
* Thus, one can conceive of three scenarios for the global economy in 2006:
1.
Continued economic growth (4.3% for world, 3.3% for the US as in IMF's WEO) in spite of high oil prices. This is the continuation of Bretton Woods 2 (BW2) regime where global imbalances remain large. Oil stays around $60-70 or above.
2.
Significant slowdown in US and global growth (2.5% and 3.4%). Oil price falls towards $40-45.
3.
US and global "hard landing" with US growth down to 1.5% and global growth down to 3%. Unraveling of BW2. Oil price crashes after having spiked above $70.
* What are then the implications of each one of these three scenarios for asset prices (currencies, stock markets, bond markets, risk premia, housing values, oil and other commodities ) and for the real economy?
* All the details and answers are in this powerpoint presentation.
Comments
I think the point you're missing is much of the pessimism that is going to cause oil prices to go up 1/3rd or more is already priced in. Without speculators driving the price of oil up, the price per barrel would be around $45. If you increase that by 1/3rd, you're looking at prices around $60, which is about where we are now. I think in a few years, once the ferver dies down, we'll see oil stabalise at $60 give or take $5.
Further, I think you'll see an increase in oil use efficiency over the next few years. In places like China and India, places with low labor costs, the price of oil can have a big effect on production costs as a pct of overall costs. There will be a big incentive to use oil wisely. The US is likely going to see a shift from gas guzzlers to cars that get better mileage. You can already see it in TV ads, where Ford and GM are marketing fule efficiency over horsepower. Hybrid cars are no longer a novelty item bought by the ultra conservationalists. I know several people who have purchased them recently are are very impressed with them.
Written by Charlie on 2005-10-03 09:01:01
Nouriel,
Re: Scenario 3...could a case alse be made that if the dollar really gets trashed in such an unraveling that the price of oil would rise nominally in dollars but fall very hard when converted into other currencies?
Written by Skoobz on 2005-10-03 11:26:07
Scenario 3 is made more likely by several aspects :
- the current topping of the world housing bubble.
Prices have topped in UK and Oz and NEtherlands and are falling gently or staying stable.
Median prices are falling in USA with sales starting to fall, while mean prices are still rising steadily ...
Present very high ratio of home ownership and very high mortgage debt level, explainding the fall in the US household saving rates (and its fall in many european countries)
- The oncoming bankrupcy law reform in the USA, with higher minimum payments necessary, the rise in interest rates which will begin to impact ARM with 2 years of delay in 2006.
Add in the huge risks taken in the derivative business by all actors.
Then Katrina's direct impact on consumer confidence, household revenues, employment, may trigger the chain for a hard landing.
But I think oil is not the right culprit, the main driver of the oncoming recession is excess in debt accumulation.
"oil importers have reacted as if the shock is temporary and decided to borrow to finance it;
recycling of "petrodollar savings" has kept long term interest rates low stimulating demand in oil importers"
If you look at any single problem, you will find people reacting by borrowing more, while others offer loans at a small rate (short term rates rise : it's temporary, katrina hits, it's temporary, the US deficit, it's temporary, wages do not rise, it's temporary, high oil prices, it's temporary ...)
recent history of credible anti-inflation monetary policies bear the blame of the oncoming debt deflation crisis. They have indeed helped to disconnect wages from productivity, fostered asset bubbles and redone all the errors made in the 1920's albeit in worse.
Written by DF on 2005-10-03 11:47:50
Written by FSG on 2005-10-04 22:12:12
Economists think that oil is merely a supply-demand affair. If $100 oil brings about a recession, then once the economic societal adjustments are made, oil prices will fall back to $40 or lower, as if oil is just like any other commodity—supply and demand. Oil, right now, is the fuel that drives the global economy. Without it, there is no growth.
The downward slope of peak oil brings a long slow economic slide. Alternate energies may be found, but none now are ready to fill the breach convincingly. Imagine the world economy slowly falling down a long flight of stairs. At each riser, it picks itself up, starts to climb back, only to fall further down.
Charlie,
Actually Katrina and Rita will delay “peak oil” somewhat. Conservation—or just not using it—really counts. And we might see a decline in prices…perhaps next summer sometime. (This winter may be hellish.) But the reprieve will be only temporary.
There are refinery bottlenecks—too few refineries--, which I find surprising and almost inexplicable. The Saudi’s have complained about this situation repeatedly. The U.S. has not built a new refinery in the last 29 years. Why? The first reason is that no one wants one in his backyard. But ask the question another way: How many new refineries have the major oil companies built worldwide within the last ten years?
Keeping refinery capacity tight does insure higher prices. Refineries are expensive projects and take a number of years to build. If a solid oil supply could be assured for the next ten or fifteen years, then new refineries would be profitable. But if the supply of refinable oil will peak, a new refinery is just a waste of money. Perhaps the lack of new refineries is not so inexplicable after all.
Written by Stormy on 2005-10-05 22:01:24
I don't understand why the oil prices are going down, from $70 peak to about $63 in a matter of a month. Oil supply and demand are supposed to be inelastic in the short run. Is there some sort of speculation going on? The following article suggests this:
capmag.com
Also, the Fed seems to be taking inflation quite seriously and is all set to raise interest rates again.
Written by Shuvro Aikath on 2005-10-06 18:36:16
Oil is backing off on seasonal adjustment. A cold winter could boost prices later but the main rise will be next spring in anticipation of summer. Increased efficiency and slowing growth may keep it from advancing to $100.
Written by Lord on 2005-10-07 15:45:14
It is true that the conditions for the oil industry are very unstable, due not only to the natural disasters and the lack of exploration and production, but also to the geopolitical conditions existing today.
However, there is no way prices will reach the $100 level. Before we see this, we will see the phenomenon of secondary industries closing down -incapable of paying the high prices of oil and its derivatives-. This will bring the demand down and since the pressure for prices is demand driven a relief in prices.
I don't see prices above $85.
Written by FSG on 2005-10-08 14:33:48
I think we are a little too focussed on the price of oil, rather than the net effect of limited supply.
How high will the price of oil go up? High enough to destroy demand that can not be served.
Are we seeing demand destruction? Of course, that is the purpose of rising prices. Cost of production has not tripled in that last five years.
A simple model of the situation would be to assume that oil production has plateaued. If this is assumed, then the number of motor vehicles on the road must stay constant (ignoring other uses of oil and fuel efficiency). If this is the case, then for every (net) car that hits the road in a developing nation, one must come off the road in a developed nation.
Lets say that current oil production can accomodate 800 million cars. That means the richest 800 million people (one person per car) will own cars and the others will have to find some other means of transportation. That is (a first approximation to) the net effect of limited supply.
Written by vorpal on 2005-10-08 15:12:15 |
