THE BEAR'S
LAIR Oil in 2012: $200 or
$50? By Martin Hutchinson
CIBC World Markets analysts recently
predicted that oil would sell for US$200 a barrel
in 2012, as oil supplies grow ever tighter
relative to demand. That would imply a continued
global boom for the next four years, which would
bring inflation, perhaps validating CIBC's
prophesy as the dollar went the way of the 1923
Reichsmark.
All the same, that's not the
way I'd bet; I think $50 is more likely. We are
probably not quite at the end of this
unprecedented oil and commodities bubble, but we
are surely getting close.
To take the
hyperinflationary possibility first. The St Louis
Federal Reserve has since 1991 calculated a
monetary statistic "money
of
zero maturity", which is M2 minus small time
deposits plus institutional money market funds. In
the absence of M3 statistics, discontinued by the
Federal Reserve in March 2006, St Louis' MZM is a
decent measure of broad money supply. MZM
increased by a moderate 9.18% in 2007. However in
the three months to April 14 2008, it has
increased at an astounding annual rate of 30.3%,
reflecting the massively expansionary monetary
policy the Fed has followed since January.
If the Fed keeps up that rate of growth
for the next four or so years, then, since prices
follow monetary growth, by the end of 2012 prices
would have risen by about 236%. In other words, to
have the same real price as today's $115, oil
would sell for $386 per barrel. A price of $200
per barrel would then represent a moderate oil
price, reflecting a decline in real oil prices to
little more than half today's level in real terms.
Needless to say, if the US dollar had been alone
in suffering this level of inflation, the euro
would in 2012 be selling at over $5 and the yen
would be running at $1 = 28 yen.
So how
likely is this hyperinflationary scenario, and how
likely is $200 oil without it?
The
hyperinflationary scenario depends on the Fed
continuing to increase money supply by around 31%
per annum for the next four years. That's not
quite impossible. Consider a world in which
Federal Reserve Board chairman Ben Bernanke has
little or no fear of inflation, but where house
prices are an essential political measure of the
Fed's success. In that case, to prevent house
prices from catastrophic decline, Bernanke might
continue to indulge in stimulatory policies,
lowering interest rates as far as practicable
towards zero, buying essentially unlimited
quantities of dodgy housing debt from the banking
system and assisting in bailouts of any banks that
got into trouble.
A sloppy populist
administration, were such to be elected in
November, might ally with the Fed in devising a
series of ever-more expansionary "stimulus
packages" while prevailing on the Fed to support
the Treasury bond market to help it fund its
trillion dollar deficits. It might assist the
process by erecting trade barriers against Third
World imports, which would be seen as taking away
jobs; such barriers would restore few jobs but
might well produce huge increases in import
prices. The rest of the world would doubtless go
into recession as the US withdrew partially from
the world market, so oil and other commodity
prices would decline in real terms, but the dollar
prices of non-oil imports could be rising so
rapidly that the overall price level continued to
inflate.
Sound horribly plausible? I'm
rather afraid it is. The 2008 campaign has shown
that the quality of economic thought among both
the US primary electorate and the political class
has deteriorated markedly in the past decade, so
that there are few barriers today to rampant
protectionism, rising inflation and
ever-increasing government spending. There are
counterproductive policies of the 1930s through
the 1970s that would probably be avoided today,
but not many of them.
There are thus only
two factors that may save us from 30% inflation
and $200 oil by 2012: a revival of good sense by
the Fed and the politicians (very unlikely) or a
full-scale revolt by dealers in the US Treasury
bond market. The latter is not at all improbable;
the government's borrowing is increasing
substantially, with the current year's deficit
heading towards $500 billion even before recession
has properly taken hold, so bond markets are going
to be asked to absorb a LOT of debt. At some
point, even with the Bureau of Labor Statistics
doing everything it can to massage inflation
figures, bondholders and dealers will come to
realize that they are being asked to buy Treasury
bonds that yield less than zero in real terms.
A good healthy "buyers' strike" would then
push up Treasury bond yields, probably forcing
Bernanke's resignation (as it did the resignation
of his predecessor G William Miller in 1979) and
force a tighter monetary and fiscal policy on the
US powers that be. It is a consummation devoutly
to be wished; one's only doubt is that inflation
has been rising steadily now for several years and
yet Treasury bond yields remain stubbornly around
their levels of 2004. Continued heavy buying by
the less than stellar intellects of Middle Eastern
and Asian cash-rich central banks could prevent a
catharsis that all should desire.
Assuming
that we get a buyers' strike in the Treasury bond
market or (less likely) a revival of good sense in
the Fed and Treasury, inflation is unlikely to
soar to over 30% and thus oil is unlikely to trade
around $200. In such an event, interest rates
would be increased to begin the lengthy task of
wringing inflationary forces out of the system.
That would reduce the flood of liquidity in
international markets, which would have two
effects. First, it would reduce the rate of world
growth, affecting particularly those countries
such as India and Latin America whose fiscal
(India) or balance of payments (most of Latin
America) position was already somewhat weak.
Second, it would greatly reduce the loan
capital available to international speculators,
which have been an increasingly important factor
in rising oil, gold and commodity prices in the
last year. There are reports that hedge funds have
already been compelled to reduce their leverage to
a maximum of five times capital. I would tend to
be skeptical of such reports, but clearly if
interest rates were forced upwards the arithmetic
both for hedge funds and for those who lend to
them would change radically.
That
scenario, of slowing world growth, particularly in
markets with heavy real estate exposure (such as
the US, Britain, Spain and Ireland) or in
over-leveraged emerging markets, would be
devastating for commodities markets. Speculative
demand would quickly be removed from them, partly
because of the bankruptcy of the speculators, and
real demand would also be somewhat reduced.
Commodity prices would fall towards equilibrium
levels.
In the case of soft commodities,
the fall towards historic levels would be rapid.
Production is already being ramped up because of
current high prices, so it is likely that in 12
months time there will be a glut of most crops.
The ethanol from corn politically inspired
disaster is registering even in the minds of US
politicians, so even if the bizarre and
counterproductive US subsidies for that process
are not repealed, they will not be extended. World
food consumption is increasing only relatively
slowly, with some change in mix as wealthier
Indians and Chinese eat more meat, so with a
further slowing in consumption growth it will take
very little time for production to catch up.
For gold and silver, the trend depends on
the outlook for global inflation. If low interest
rates are allowed to persist until inflation has
got a real grip, it is likely that inflationary
expectations will worsen, driving up gold and
silver prices further.
Even when interest
rates are raised, confidence in government
firmness against inflation will probably be slow
to revive, so speculators and investors may
continue to hold gold and silver as a hedge -
after all, with rising interest rates stock and
bond prices will be declining, so there won't be
an obvious alternative home for their money.
Thus the equivalent 2012 prediction to
$200 oil, $2,000 gold, may very well be possible,
although it is likely that such a price will be
seen only early in the year, with the overall
trend by then, perhaps two years into the fight
against inflation, being firmly downwards.
Finally, the oil price itself. Two factors
have been driving the rise in oil prices. One,
rising demand, has been discussed in relation to
food and can be expected to follow the same
pattern. As the world economy slows, demand will
increase more slowly, while the speculators will
be squeezed out of the market by higher interest
rates. Nevertheless, absent changes on the supply
side, one might still postulate 2012's oil prices
to be close to current levels.
It is on
the supply side that a global recession makes the
most difference. Here the continually rising price
of oil over the past five years has awakened
primitive nationalism in oil-producing countries,
causing them to maltreat foreign oil companies and
attempt to squeeze as much government revenue as
possible out of the oil goose that is laying so
many golden eggs.
New oil discoveries are
becoming more and more difficult because in only a
few countries are oil companies with modern
exploration techniques given the right incentives
to search aggressively for oil. Even Russia, the
white hope for greater oil production five years
ago, has seen its production begin to decline in
2008, while Mexico (closed oil sector), Venezuela
(socialist fruitcake) and Nigeria (kleptomaniac
government that taxes oil revenues at 98%) have
all seen oil production decline by more than 10%
since 2006.
There are a few
counterexamples: Iraq’s oil reserves have doubled
since that country was reopened to international
exploration in 2003, while Brazil, whose Petrobras
enters freely into joint venture agreements with
Big Oil, has made major new oil discoveries
recently. However, while oil prices continue to
rise the search for new oil sources is likely to
be restricted to only a limited number of
geologically promising areas.
Once oil
demand starts to tail off and interest rates rise,
the current situation will reverse. Badly run
countries such as Venezuela and Nigeria will
quickly run out of money. Current policy will then
be reversed, and the major oil companies will once
again be allowed to explore and produce on an
efficient and profitable basis.
Oil prices
will then decline more rapidly, and wealthier and
better-run oil producers such as Russia and Saudi
Arabia will also find themselves in difficulty and
become less recalcitrant in international politics
and less resistant to help from the multinational
oil companies.
Slackening oil demand will
also give time for new supply to come on stream
and for environmental objections to massive supply
from tar sands and oil shale to be overcome. The
result, as in 1981-86 will be a decline in oil
prices, gradual at first but probably accelerating
until a floor is reached at which new exploration
becomes pointless and the oil price is once again
as far below its long term marginal cost as it is
today above it.
By 2012, that process will
only have gone part way; nevertheless an oil price
of $50 before the end of that year seems probable.
Oil prices may well be on a long-term upward
trend, as supplies become restricted to
geologically and politically more difficult areas,
but $50 per barrel is already (absent
hyperinflation) well above the real oil price in
1986-2002 and should easily prove sufficient to
reward both efficient exploration and more
intensive production from the tar sands of Orinoco
and Athabasca.
Just as in stocks and
housing, the price of oil cannot go up forever.
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found at www.greatconservatives.com.
(Republished with permission from
PrudentBear.com . Copyright 2005-07 David W Tice
&
Associates.)4/29/2008
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