Asia/Pacific: Oil Is a Bubble
Andy Xie (Hong Kong)
The impact of high oil prices on China’s economy and on profit margins in general is a key risk in the current global boom. If current oil prices persist, the windfall for oil exporters may exceed the total earnings of S&P 500 companies, and China will have to pay 2% of GDP more in 2005 than last year for oil imports.
China is a low-income economy and cannot sustain its rapid growth at current oil prices, in my view. Although current oil prices are still half as high as their peak during the oil shock in the late 1970s, China’s per capita income is less than one-tenth of that among the OECD economies at that time.
The global property bubble has covered up the impact of high oil prices so far. Anglo-Saxon consumers have leveraged their rising property values to overcome sluggish income growth and high oil prices, thus sustaining consumption growth. Chinese investors expect massive profits from property inventory in a rising market and are willing to absorb the higher materials costs as a result.
Oil is a bubble because the strong demand reflects the global liquidity bubble. At the same time, financial investors have poured into this commodity. When the demand-supply balance is tight in a strong global economy, demand from financial investors can push up prices rapidly. Hence, even though financial investors lose some money for carrying a commodity without yield, the price increase in the short term can still make the trade very profitable. Without the demand from financial investors, the current oil price could be US$15/barrel lower, in my view.
The oil and property bubbles are aspects of the global liquidity bubble that has arisen from the combination of a low US Federal funds rate and the willingness of Asian central banks to accumulate foreign exchange reserves. The property bubble is the primary manifestation of this liquidity. The oil bubble is a secondary aspect. Oil, however, could destabilize the equilibrium through its contractionary redistributing effects.
ChinaCannot Afford Such Expensive Oil
During a liquidity bubble, sensational claims (e.g., “the world is running out of raw materials” or “1.3 billion Chinese soon consume like Americans”) tend to proliferate, juicing up the prices of oil and other natural resources. These have almost always turned out to be false. Oil prices have averaged twenty-three 2003 dollars per barrel since 1861, when oil was first sold as a commodity, similar to the average price of twenty-six 2003 dollars per barrel over the past 50 years.
Current oil prices are still half as high as their average during the oil shock in the late 1970s, which caused a global downturn. The OECD economies are much less dependent on oil, and current prices are not very high relative to their income. They should be able to cope with current or even higher oil prices.
China, however, is a different story, and it is driving oil prices today. Current prices are much higher relative to Chinese income than oil prices during the oil shock were relative to OECD income at that time. China’s per capita income may reach US$1,500, with urban income twice that high, in 2005. In today’s money, US per capita income was US$25,000 and Japan’s US$18,000 in 1980, at the peak of the oil shock. Even though current prices are still half as high as this peak in real terms, they are already much higher from China’s perspective.
But Property Bubble Covers Up Impact of High Oil Prices
The private auto fleet is quite small in China, and most oil is for industrial use. There is little pricing power in either the consumer or export market. The property bubble is where the impact of high oil prices has been absorbed. Property under construction reached 1.4 billion square meters by the end of 2004. The expected price increase is about US$60–80 per square meter per annum, we estimate. Hence the expected profit on the inventory is about US$84–112 billion per annum. China consumed about 7 million barrels/day of oil last year, and paid US$20 billion more due to higher prices and a further US$16 billion more due to higher volumes than in the previous year. The expected massive profit in the property inventory is why the Chinese economy has not felt the pain so far.
The value of US household real estate increased by about US$2.2 trillion last year, or 20% of 2003 GDP. US oil consumption was about 20.5 million barrels per day last year. WTI crude averaged US$10.5/barrel more in 2004 than in 2003. Even if producers managed to pass all the increase in oil prices on to consumers, it would still have cost US households only US$78.6 billion, which looks quite small relative to the property appreciation.
China’s Property Bubble May Deflate First
Even without property appreciation, higher oil prices would have much less effect on the US or other OECD economies than on industrializing economies in Asia. Asia ex-Japan consumed about 17 million barrels/day, compared with 20.5 million for the US last year. But the US economy is three times as big as that of Asia ex-Japan. The comparison with Europe or Japan is even less favorable, as these are more efficient than the US in using oil.
As the oil bubble is a reflection of the global liquidity bubble, we would expect liquidity tightening to bring oil prices down. However, Federal Reserve Chairman Greenspan is in no mood to pop the bubble at the moment. The ‘measured pace’ of raising interest rates in the Fed policy statement has encouraged more speculation, i.e., more demand for money at the same interest rate. This policy has amplified the liquidity bubble in the past year, even though the Fed has been raising interest rates.
China’s property bubble could deflate under its own weight. The number of residential properties under construction exceeds 10 million, or about 8% of urban households. The current average price exceeds 10 times urban household income nationwide and is more than 20 times in many cities of the Yangtze Delta region. The probability that all these properties can be sold at current or even higher prices is quite low, in my view. As soon as property prices begin to fall, the pain from high oil prices will be felt by the economy, and the demand for oil will likely decline sharply.
Oil Exporters May Spend Their Windfalls
The major oil exporters in the Middle East, the former Soviet Union, Africa, and Latin America received a windfall of US$415 billion last year, on average oil prices of US$38.3/barrel for Brent crude (relative to the average price of US$22/barrel during 1980–99). Total earnings for the S&P 500 companies were US$560 billion last year. If the price of Brent crude averages US$45/barrel this year (as most analysts are now predicting), the windfall for these oil exporters could total US$610 billion.
As discussed above, the impact of high oil prices on earnings has been offset by the property bubble. As long as global property prices remain high and rising, the high oil prices may hurt the earnings of some companies, but will boost others’, and hence probably will not bring down the overall level.
What the oil exporters do with their windfall will have a huge impact on interest rates and, hence, the sustainability of the current liquidity bubble. Anglo-Saxon trade deficits have surged in this cycle, and so have oil windfalls. As trade balances must add to zero globally, why the surplus economies do not spend their money is as important in determining real interest rates as why the deficit economies do spend their money. As real interest rates in the Anglo-Saxon economies remain unusually low despite their large borrowings, it suggests that the oil exporters are not spending their windfalls.
If the oil exporters believe in the sustainability of the current high prices, which they don’t … yet, despite their rhetoric, it could tighten global liquidity conditions considerably -- despite Mr. Greenspan.
morganstanley.com |
