The Coming Oil Price Shock

By: Andrew_McKillop

Fatal Difference - Fatal Indifference - We need only to recap the experience of the 1970s and 1980s to understand why massive public national deficit financing of Keynesian-type spending to restore global economic growth will almost surely end with a 1970s style oil shock. That is oil price explosion, falling consumer confidence and corporate investment, falling economic growth, finance sector panic, competitive devaluation of world moneys and a catastrophic slump back into recession. Like the 1970s experience, the recession will be very inflationary.

Then and Now

The 1970s delivered two short-sharp oil shocks, with never-known-before massive rises in the oil price, unlike the slow but permanent oil shock that operated through 2003 to the collapse of the global economic growth surge in 2008. Rising oil and commodity prices until 2007-2008, neither ironically nor magically, surely levered up global economic growth in a process I call Petro Keynesian Growth and the IMF and Federal Reserve Bank of New York calls fast, near complete recycling of windfall gains by major capital surplus oil and gas exporter countries - including Russia, for example. The petrodollars and petroeuros are quickly recycled to the global economy, raising solvent demand. This didnt happen in the 1970s.

This growth levering process operated in the Petro Keynes interval of 2004-2007, before the traditional model, Deficit Keynes, was called in to rescue the imploded finance, bank and insurance sector of most OECD countries, from midyear 2008. While the petrodollar recycling stimulus was figured in the high giga dollar range, the new debt racked up by OECD political deciders rushing to save the banks and slow the plunging economy was tera dollar sized, with peta dollar ultimate wipeout no longer a fantasy notion when or if Weimar Republic hyperinflation surges as a result.

For students of history we can note the oil price rises in the 1970s shocks were about 295% in 1973-1974, about 115% in 1979-1980. Through the 9 years from 1999 to Q2 2008 prices rose about 950%, all measured in nominal dollars not inflation adjusted.

Now and the Near Term

In 2010 another 100% hike, or doubling from the current price level around US$75 a barrel is possible or probable if there is any kind of global economic recovery. It is also possible or probable if both the Euro and the US dollar fall in value, following the present panic, inciting oil and gas exporters to cover near-term risk of further devaluation and/or inflation in the countries emitting these moneys. In a worst-case scenario, where we also have a rise in geopolitical insecurity as the USA finally quits Iraq and the Afghan war is declared an unwinnable high cost vanity project, and Israel runs a bungled regime change attempt against Iran, prices could triple from current levels very fast.

The big difference between the 1970s shocks and what has happened since around 2005 or 2006, is that the 1970s oil shocks were caused by short and sharp oil supply cuts for political reasons. Since 2005 or 2006 it is clear that global oil output simply doesnt respond to rising prices, in the exact same way gold production plays dead in response to record prices. Among the factors causing this we have the no-no for government friendly media, called geological depletion. Asking why BP drills 5 kilometres into the Earth's crust in 2 kilometre deep water instead of seeking "highly abundant" land-based oil reserves is a useful question: perhaps BP does this for technological kudos, to keep offshore rig builders in business, or for ecological experimentation with toxic dispersants ?

In the 1970s and 1980s world oil production capacity kept growing on the back of accumulated and large discoveries. Any prospect of physical supply shortage was removed from the scene for at least the next 20 years. Time then ran out.

Now we have a guaranteed short fuse, low ceiling, fast feedback on oil prices when global oil demand recovers. When we get to real Post Peak Oil and a net annual capacity outturn of zero, with any new capacity added only replacing lost, the price linkage will be even closer - and the splendid 75% price crashes like late 2008-midyear 2009 will be a thing of the past. The tilt to permanent high prices is totally predictable in the next 3 - 5 years.

With the Slump Dividend gone, we can focus on permanent high priced debt joining permanent high priced oil in the new inflation party. Ironically, this could save the party in the early lead-in phase, through 2010-2011.

The Coming Recovery

Due to the Slump Dividend of sub-critical oil prices, barrel prices below about US$ 125, the Petro Keynesian lever is alive and well, and working to the benefit of China, India, Brazil, South Korea, Australia and other countries. Below the critical level, oil and energy prices are not high enough to impact food prices, industrial materials, sea transport and construction costs, and consumer confidence in those economies able to run with the

Petro Keynes lever.

Global economic growth can or might pull the most-affected (that is most debt riddled) OECD countries out of their semi-structural slump, during the rest of 2010 and into 2011. By then, however, oil prices can again go critical leaving us with the 1970s default solution. Through 1974-1979 the response was to print money, like today, but to also accept the inflation caused by printing money. Today's political deciders in the debt riddled OECD countries maintain a herd facade of "struggle" against inflation being second only to "struggle" against Al Qaeda, and sometimes even in front of it, in the big list of national salvation quests.

Keeping the party going beyond end 2010 will mean accepting inflation. If this is linked to slow-or-no economic growth, it can tilt to hyperinflation. The coming economic recovery, if it comes, will be inflationary. In the famous slogan of Thatcher, parroted by generations of other great leaders: "There is No Alternative".

Geological shortage is not responsive to regime-change of oil exporter countries, as the Iraq situation shows, despite the brave words of its Chi'ite leadership bragging they can outproduce Saudi Arabia. Economic policy regime change is a lot easier, and is coming in the debt riddled OECD countries of Europe quite soon.

Inflationary growth, growth at any price, any cost, is the only way out. World oil demand will recover, oil prices will then again spiral as in 2007-2008 and with or without the help of Goldman Sachs structured products.

Coming Oil Demand Cuts

Using IEA and OPEC data, world oil demand in 2008-2009 declined at around 3.5% a year before stabilizing late in 2009, and showing low growth from the start of 2010. The bad news is that long-term contraction of world net export supply or "offer" (also caused by oil exporter countries actually consuming oil themselves) is likely already on a downslope of about 1% a year and will soon move up to 2.75% to 3% per year. Permanent recession becomes the default solution if oil prices are the bogeyman. Put another way, the present recession, described by the IMF as the worst since 1945, and the present OECD debt crisis the IMF tends not to talk about (because unprecedented) delivered a temporary cut in global oil demand at somewhat less than the coming long term trend rate for cutting global economic intensity of oil demand.

Demand compression will be difficult to set for India, China, Pakistan, Brazil and the main oil exporter countries like Russia, Saudi Arabia, Iran, Venezuela, UAE and others. This signals oil demand capping, and programmed year-on-year oil demand cuts will have to come from the OECD countries, essentially the (unacknowledged) basis of the European "20-20-20" plan, dressed up in climate-change frills. On average, the OECD countries use about 5 times more oil per head of population than China and 9 times more than India.

The main danger is that nice intentions on long-term oil intensity cuts will be shortcircuited by real world energy demand growth due to economic recovery in the real world near term. Previous instant remedy solutions of the Bush-Blair model, regime change of targeted oil producer countries to improve their export performance, are too slow and are always bungled, meaning that controlled cuts in oil intensity become the No Alternative.

Put another way, attempts at regime change to improve oil export performance will be decreasingly attractive due to very slim spare capacity margins for oil export supply. The sharp rise in oil prices through 2010 will have to be swallowed, because progress in restoring OECD economic growth is no longer an option - but a life or death need. Time is now short and oil intensity cuts are now urgent. Achieving perhaps a 75% reduction of oil, gas and coal intensity of the economy by around 2035 will need large investment, industrial restructuring, economic restructuring, legislative action, lifestyle change and consumer communication. Dressing this up as saving the world from climate catastrophe has not worked making the coming shaky economic recovery a period of epochal change

The challenge of energy transition is very clear. Organized dialogue between oil exporter and oil importer countries, aiming for stable and high but tolerable oil prices, in a transparent supply and pricing framework linked to energy transition. This will be vastly more productive than heroic attempts at printing money to beat the debt bulldozer or trying out new regime change adventures in oil exporter countries.

By Andrew McKillop

gsoassociates.com

Project Director, GSO Consulting Associates

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

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