THE BEAR'S LAIR Time to do something about oil By Martin Hutchinson
The oil price rise of more than US$50 per barrel since the US Federal Reserve
started cutting interest rates in September is beginning to get serious. Since
the rise of oil import prices alone removes $170 billion from the US economy,
more than 1% of gross domestic product, it is both inflationary and highly
recession-producing, especially since it has been accompanied by similar rises
in other commodity prices. Its full effects have not been seen yet but they're
coming - don't worry! At some point we are probably going to have to do
something about it. The question is: what?
In general, the populist clamor to "do something" about a sharp
move in commodity prices makes no sense. The price mechanism acts as a shock
absorber for supply and demand hiccups, so that if storms shut down the Gulf
oil platforms or rapid growth in China causes its use of automobiles to soar,
oil price rises can signal to other consumers to cut back consumption and to
producers to enter into new exploration projects.
That's why the fuel subsidies in Third World countries are foolish. They
encourage the consumption of a substance that is increasingly scarce and at
times like the present impose an appalling burden on local taxpayers or the
government's financing mechanisms (as in India, where government deficits
threaten to derail that country's magnificent economic boom.)
While oil prices were rising from $20 to $80 per barrel in 2002-07, this
rationale seemed unquestionable. The rise was gradual, and the price remained
well within the parameters that the world economy had survived, albeit with
some difficulty, in the early eighties. (Although the peak 1980 price of $40
per barrel was equivalent to about $105 in today's dollars, that peak was
ephemeral; the major economic effect of expensive oil came from the roughly six
years of oil prices hovering around $30, or $70-80 in today’s dollars, in
However, the $50 rise since September has been sudden, has taken oil prices to
a level never before experienced, and shows no sign of abating. Its principal
short-term cause has been the excessive lowering of interest rates and
relaxation of credit conditions in the United States and elsewhere, but there
are a number of long-term factors which may make it difficult to reverse.
The International Energy Agency (IEA) is said to be producing a study showing
that future oil supplies will be more restricted than had been thought, topping
out at about 100 million barrels per day rather than the 115 million that had
been thought necessary to accommodate the world's growth to 2030. The IEA's new
caution is probably inevitable, given the rise in prices and the considerable
uncertainty in reserve and production estimates; it's mostly a matter of IEA
geologists seeing the inexorable rise in prices and deciding to use more
pessimistic assumptions about future trends.
In any case, since current production is only around 85 million barrels per
day, the decline in estimated future production is not an immediate problem.
However, its psychological effect on the market is considerable.
Whatever the views of the IEA, it should be clear that the recent rise in oil
prices is not driven by fundamentals. Economists differ about the price
elasticity of oil, but the lowest plausible estimates for short-term price
elasticity are around 10%, with medium-term elasticity being much higher. Thus
if oil legend T Boone Pickens is right that oil supplies are currently 85
million barrels per day and oil demand is 87 million, that is a supply
shortfall of 2.4%, which at a 10% elasticity should produce a price increase of
24%, not 60%.
The principal influence behind the huge rise in oil prices has been
speculation, whether by the international oil companies, by hedge funds
deprived of easy pickings in the housing and equities markets, or by the oil
suppliers themselves, drunk with the glory of their new-found wealth.
Naturally, easy money provided by Federal Reserve chairman Ben Bernanke,
European counterpart Jacques Trichet and the rest of the gang since September
has empowered the speculators. Indeed, while real interest rates remain below
zero oil speculators would appear to be on to a one-way bet, provided they are
rich enough to sustain their buying - and the combined resources of the world's
hedge funds, oil companies and dubious energy-rich Third World dictators are
very great indeed.
Hence if we do nothing, but continue to focus on housing, consumer inflation
and the NBA playoffs, oil prices will continue rising. This will have only a
modest short-term effect, but a highly damaging effect in the medium term, as
the recession-producing tendency of high oil prices works its malign magic on
the long-suffering world economy.
Further rises are additionally dangerous because they may not quickly be
reversed. In a market of entirely rational trading robots, the 1980 oil price
spike to $40 might have been just a spike, with prices reverting within weeks
to the $15 or so that was then the equilibrium. In the world of fallible
speculators and other humans, the psychology of a rise to $40 made the price
"sticky" on the downside at around $30, so that it was November 1985 before
prices collapsed to $10. Thus if the oil price soars to $200 next week, we are
probably condemned to $150 oil until 2013 or so, after which the price will
collapse to $25 for several decades, as new supplies and bizarre and expensive
government-mandated conservation schemes overwhelm the market.
To avoid this dreadful fate, what should we do? There are a number of
We could invade somewhere. Considered as an oil acquisition exercise, Operation
Iraqi Freedom has been a smashing success, and only appalling Wilsonian
wimpiness in the US government has prevented the United States from taking full
advantage of it. Iraq's known oil reserves have been increased by about 100
billion barrels since the invasion, as competent US oil companies have been
free to explore for new oil employing techniques more advanced than the
40-year-old dowsing sticks used by Saddam's oil operation. At today's oil price
of $130, less a generous $20 for drilling and extraction, those additional
reserves have a value of $11 trillion, or approximately 10 times the most
alarmist estimate of the cost of the war to date.
The problem is that the US did not secure itself a proper royalty on the new
oil finds (even 10% would have been worthwhile - $1.1 trillion over the next
few decades.) Nor did it ensure, by setting up a privatized oil company and a
trust fund for the Iraqi people diverting oil revenues from the Iraqi
government, that the new oil finds would be exploited in an efficient manner
and the supplies directed properly into the world oil market. Any future
invasion of an oil-producing country should avoid these two mistakes and thus
make itself self-financing.
The obvious place to invade is Venezuela (even if current estimates of
Venezuelan and Saudi reserves are wrong and there is in reality more oil in
Saudi Arabia that could be unlocked if ExxonMobil and the boys were given free
rein, the Saudis are nominally our allies, so an invasion would be considered
unsporting by world opinion.) Since the 1.8 trillion barrels of Venezuelan oil
deposits consist largely of the Orinoco tar sands, a Venezuelan oil-related
invasion would impose an additional requirement: to keep the environmentalists
away in order that reserves could be exploited with maximum efficiency.
For those who feel that invasion-for-oil is altogether too Bismarckian in its
implications, there are other alternatives. The most effective would be to use
the interest-rate weapon, reversing the damage caused by the cuts since
September and ideally going a little further, to fight the resulting consumer
price inflation. A series of small interest rate rises would not be effective,
because it would enable speculators to adjust. (The 0.25% rate rises in
2004-06, all 17 of them, we now know were completely ineffective in quelling
housing speculation as they allowed the speculating frog to bask in the
gradually warming interest rate water, rather than being forced by a sudden
temperature rise to jump out of the saucepan.)
The most effective interest rate trajectory would probably be an immediate
reversal of the post-September cuts, jumping the Federal Funds rate from 2%
back to 5.25%. This would still be too low to be effective in fighting consumer
price inflation, currently around 4% even on the suspect government figures.
However it should shock commodity speculators sufficiently to cause a sharp
drop in oil and commodity prices which might, if we were lucky, become
self-reinforcing enough to push oil prices down to the $80 level, which is
probably the lowest we can currently expect. Once the immediate effect of
higher interest rates had worn off, further rate rises, probably to around an
8% Federal Funds rate, would be needed to wring out inflation, but those could
be undertaken over the next 18-24 months in the normal manner.
It is quite certain that the interest rate weapon, if used with sufficient
vigor, would quell oil prices, but it's not entirely clear whether a single
rise to 5.25% would do it. However, draconian rate rises beyond 5.25% to quell
oil price rises would be deeply unpopular and would cause further catastrophe
in the US housing market. Since invasion is presumably off the table, the
political classes may thus attempt to impose other remedies for high oil
prices, all of which would be either counterproductive, disastrous or both.
These might include some or all of the following:
Price controls on oil companies. These would have the cathartic effect of
eliminating the profits of Western oil companies, but would have little effect
on the market, since the majority of oil supplies are today not controlled by
Western oil companies.
Subsidies. The effect on consumers of spiraling oil prices could be reduced by
cutting petroleum taxes (as recently proposed by Senators John McCain and
Hillary Clinton) or subsidizing gasoline prices directly. Such subsidies would
increase rather than reduce consumption and would divert income from taxpayers
(the ultimate providers of the subsidies) to the Organization of Petroleum
Exporting Countries and other oil producers. Terrible and counterproductive
Rationing. Britain did this at the time of the Suez crisis in 1956, when
overall rationing was still a recent memory. Its initial psychological effect
would be considerable and it might well prove politically appealing to a
populist, economically illiterate president after January 2009. The principal
gainers from such a measure would be the Mafia, who would find a new business
in stolen and forged ration coupons.
Intensified corporate average fuel economy (CAFE) standards, ethanol mandates
and public transportation subsidies. These would be highly politically
attractive to the left, and are thus probably quite likely. Their effect would
be far too long term to change short-term price movements. Apart from
increasing costs in the economy, they would result in tens of thousands of
additional fatalities a year, as the feeble mini-cars took to America's roads.
Intensified drilling in Alaska and offshore US areas. The right-wing
alternative to CAFE standards; equally ineffective in the short term but much
more helpful long term. Would probably intensify the 2013 price collapse as the
new sources came on stream.
Closing down the commodities exchanges. The speculators have already found the
counter to this one; a new crude oil contract is opening for trading in Dubai.
To close that down, we would need to revert to the invasion option.
In summary, a sharp rise in US and world interest rates is the best way to
solve the problem of spiraling energy and commodity prices, which will probably
not solve itself. If that doesn't work or is "politically impossible" it's time
to prepare the 82nd Airborne for jungle warfare in the Orinoco Basin.
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.)