Cheap oil myth and energy transition

<a href=www.vheadline.com>Venezuela's Electronic News Posted: Tuesday, June 03, 2003 By: Andrew McKillop

VHeadline.com petroleum industry commentarist Andrew McKillop writes: Record economic growth and high oil prices ... the US economy attained it highest-ever post-war growth of real GDP ... achieving what today would be the completely unthinkable rate of 7.5% ... in the Reagan re-election year of 1984. Before inflation adjustment, the economic growth number was about 10.75%.

In the whole postwar period, from 1945-2003, the US has never exceeded that rate of growth. At the time ... in dollars of 2003 corrected for inflation and purchasing power parity ... the oil price was around $60/barrel.

Those well-publicized economists and journalists who claim that “high oil prices hurt growth” must explain this simple fact of US economic history ... or abandon their constant call for cheap oil as the ‘passport to growth.’

Before that year of record US growth, in 1980-82, the industrialized world had experienced its deepest recession since the 1930s, with interest rates attaining extremes today associated with the meltdown process in Latin American and African countries unable to achieve ‘structural adjustment’ ... US base rates exceeded 22%/year in 1981.

In other developed countries, national governments vied with each other to crank interest rates ever higher, in a race to cut economic activity, and to slash demand for oil, thus cutting its price and the inflation that economic and business milieu believed was solely due to oil price rises.

The extreme interest rates of the time, however, themselves limited any rapid fall in inflation for the simple reason that more expensive money was added to the list of things that got more expensive, and geopolitical uncertainty maintained oil prices at very high levels, just exceeding $100-per-barrel in today’s dollars, in early 1979.

• Through 1980-82 world stock markets therefore plunged, wiping out the gains they had made during the fast recovery and economic expansion of 1975-78, following the 1973-74 Oil Shock, but after which interest rates had not been violently raised.

Today, the world’s oil supply system is both fragile and stretched to the limit. Several key suppliers, both large and small, are intensely exposed to the sequels of many years in which oil revenues, in real terms, retreated each year. Not only have their installations and equipment been neglected, not renewed or given reduced maintenance, but their economies and civil societies are exposed to the stress and tension that declining real revenues entrain.

In the worst case of national unrest, civil war or military conflict, production and exports can rapidly diminish or even be shut down to almost nothing. The loss of even 5% of world supplies (about 3.9 million barrels/day), if maintained over a few months, would likely trigger a free-for-all bidding spree on the world oil market that could push oil prices above $75/barrel. This context could then entrain finance ministers of the OECD countries into a round of interest rate hikes, despite the almost unlimited risks this would bring for world stock markets and the world economy at this period in time.

Using the interest rate weapon would be suicide, today

Through 2000-2002, and into early 2003 world stock markets suffered a slow motion meltdown, pushing index levels back to those of the mid-1990s. Since the end of the Iraq War there has been no substantial and convincing recovery.

Total losses of notional ‘value’ on world stock markets are around $ 6 000 Billion. Attempts at explaining this as wholly or mainly due to oil price rises since late 1998, when the most recent trough in prices was reached (about $9.70/barrel or well below the real price in 1973) have a hollow ring, and investors above all hope for lower interest rates, which they feel can increase economic growth, or at least limit the rout on stock markets.

Any attempt at raising today’s interest rates to double digit levels in the OECD countries, conversely, would most surely and certainly entrain complete collapse of world stock market indices, runaway ‘domino effect’ bankruptcy of many major corporations, mass layoffs and unemployment, and grave problems for the financing of structural trade and budget deficits of the US, the UK and other countries.

The intensifying fall of the US dollar, depriving commodity exporters whose exports are traded in dollars of real revenues at a time when many minerals and agrocommodity prices outside oil and gas are at near record lows, is itself an increasing downside factor for world economic growth.

Yet recourse to the interest rate weapon when or if oil prices climb through sensitive and psychological barriers, like the $40-45/barrel range, could well intensify the flight from the dollar rather than bring it rapid new strength, while the UK pound might be shielded to some extent by its declining petro-money status, before it is almost inevitably abandoned with UK entry to the Euro. Any use of the interest rate weapon in the face of fast-rising oil prices would likely entrain and OECD-wide recession, and further destabilize the lengthening list of ‘emerging’ economies with severe debt and financial restructuring burdens.

No longer ‘awash with oil’

Current world oil output of about 78 million barrels/day (Mbd) includes that by 24 producer countries whose output is well beyond peak, and falling, with some in decline at over 4%-per-year.

Annual demand increase on a worldwide base is forecast by many influential sources (like the US EIA and OECD IEA) as likely to be above or close to 1.6 Mbd. In less than 6 years, at that rate of demand growth, a “new Saudi Arabia” is required to satisfy the increase in world demand.

• No “new Saudi Arabia” will be discovered, proven, developed and produced.

As the special case of Iraq shows, major producers can almost overnight collapse, with restoration of production capable of satisfying even domestic needs still being quite far into the future at this time.

Oil discoveries, rather than makeover and proving work on older fields, are at best one-fifth of annual consumption on a worldwide base. Underlying this is the simple fact of physical depletion of the world’s geological reserves of oil, as the world moves towards Peak Oil, or the absolute peak of production that can be achieved. This is probably below 85 Mbd.

The expansion of nuclear electric power ... at one time believed to shield against rising oil prices through producing far-from-cheap energy ... is almost everywhere stalled, with the number of reactors in service actually declining (from 443 to 441) in the last 2 years.

No genius is needed to decide what these and other facts strongly imply for oil prices. Using interest rate hikes to provoke a so-called ‘soft landing’ or controlled fall in economic activity, leading to a fall in oil demand and a fall of oil prices if producers do not cut back their export offer as demand shrinks, is a dangerous weapon at this time.

World population growth continues at around 85 million persons per year and the world economy has changed since the early 1980s, and even since the 1990s in which oil markets were “awash with oil,” in the finance and business columns if not in the facts. The oil-lean service economies of the aging OECD countries have massively de-industrialized and outsourced their manufacturing activity, first to the Asian Tigers, and now to China, Brazil and India. This change will itself set a high floor to any worldwide falls in oil demand when or if the OECD bloc decided, foolishly, to engage a round of interest rate hikes to master the challenge of higher oil prices.

Oil price collapse can be bad for the bourse

Through 1986 ... from December 1985 through August 1986 ... oil prices were nearly divided by three, that is fell by about 65% in 8 months, to around $11.50/barrel in dollars of 1986, for many light blends.

Absolutely no spontaneous, self-reinforcing increment to economic growth was recorded in any OECD country. The economic myth concerning oil prices, that ‘cheap oil favors growth’ was proved false, although the high oil prices of around 1983-84, as confirmed by the facts, in no way prevented the US attaining its highest-ever rate of economic growth.

• Worse still, for defenders of Cheap Oil, the 1986 oil price collapse likely contributed to, or even triggered the 1987 Wall street crash.

Following the collapse of oil prices, through 1986-87, there had been a feverish speculative boom of stock market ‘value’, based on expectations of rapid increases in economic growth being generated by cheap oil. No significant growth of the economy or business profits occurred in any major OECD country. As a direct result of this, stock market ‘value’ became completely unrelated to the underlying economy and suffered a major correction in the October 1987 world stock market crash, with a nominal loss of paper value above $1,850 billion. Before the ‘slow motion’ crash of 2000-2002 this was the biggest-ever stock market rout since 1929, the Mother of all Bourse Crashes.

Oil price hikes or interest rate cuts to stimulate growth?

Economic policymakers should understand that if, or rather when oil prices attain $40-$50/barrel in dollars of 2003, and are maintained in that range, global economic adjustment to higher prices can restore economic growth worldwide. The revenue impact of increased oil and energy prices, entraining higher earnings for exporters of energy-intense commodities, can rapidly improve the prospects for growth in the straight majority of the world’s economies.

With or without inflation, higher oil prices that are not resisted by slugging interest rate hikes can ease and speed structural reform and financial adjustment in many, sorely-pressed primary commodity exporter economies.

In the recent context of unstable, low real oil prices, and present context of crumbling consumer confidence in OECD countries due to fears of job losses, terrorism, climate change and other worries in what are essentially consumption saturated economies, few other strategies for restoring conventional economic growth in fact exist.

Lower interest rates (rather than symbolic reductions of a quarter-point) can be discarded as any rational or even possible strategy for the simple reason that US, European and Japanese base rates are at historic lows, in some cases their lowest for 50 years!

Any further cuts in US interest rates, notably, would most surely lead to flight from the dollar and a rapid aggravation of US trade deficits, with increased inflation. This would be dramatically intensified by oil producers shifting to the Euro as their trading currency. Conversely, increased trade deficits for the US due to higher oil prices (and oil imports make up no more than 25% of the US trade deficit at an oil price of $40/barrel) may well at least be contained if some confidence in the dollar can be maintained.

Long-term adjustment to higher oil prices

The writing is surely on the wall for cheap oil, for the very simple reason of physical depletion. Large oil price rises are coming within the next few years. This may be with or without military adventure in Iraq or ‘regime change’ elsewhere, and whatever is done with ‘strategic’ petroleum reserves, the constitution of which always increases total demand.

A structure of higher prices will likely generate relatively rapid falls in oil demand by the OECD North that are more than compensated by increasing demand in the NICs and low income countries, when oil prices continue to move up and through the $60-65/barrel range, due to continued supply constraint and the growth of solvent economic demand in the non-OECD countries. Due to terms of trade and revenue effects entrained by much higher oil prices – most metals, minerals and agro-commodities tracking or exceeding oil prices in their price movement relative to manufactured goods and services imports and purchases ... oil prices at significantly higher, and firmer levels can aid necessary transition of low income countries.

Greater liquidity in the world economy, with relatively low interest rates can enable poorer countries to break free from their indebtedness to the North’s financial institutions, have real freedom of economic policy choices, and avoid development strategies entraining total dependence on fossil fuel-based economies. Their experience of the Neoliberal 1980s should give them reason to consider more autonomous or autarchic domestic development as a better choice than pursuing the impossible strategy of Globalization.

Victims of this, like Argentina and a string of African countries, are there to provide concrete examples of what this illusory policy does to the economy, to the finances of weaker countries, and to human wellbeing.

Oil price triggered change in rich countries

Conversely, in the OECD North and particularly the USA, oil price rises to around $60-70/barrel will firstly and mainly provide a ‘wake up call’ not only for their stagnant economies, but for needed restructuring of the economic system and cultural values.

Apart from hand-wringing and tub-thumping, and of course military adventures, there will be little margin of action and decreasingly few options open to political and economic decision makers.

As noted above, the ‘interest rate weapon’ at this time is more than a double-edged sword; cranking interest rates to double-digit levels in reaction to oil price rises driven by physical depletion is not only unreasonable but will almost certainly bring about another 1929 crash and Great Depression.

In addition ... and within about 12 months from any upcoming Oil Shock ... increased solvent world demand will trickle up to the OECD North, in the form of increased demand for higher value manufactured goods and sophisticated services supplied by the North.

Shrinking growth of oil production due to geological depletion will tend to lock on oil prices at higher levels. Soon we will no longer hear, even less believe, that the world is awash with oil.

Maintained higher levels of world oil and energy prices, and prices for energy-intensive commodities ... that is real resources ... will enable and facilitate long-delayed, but inevitable structural changes of the energy intense OECD North economies.

Overall restructuring, both social and cultural, as well as economic, can easily achieve large compression of per capita oil demand. In the USA, currently using about 26 barrels per person/year, and without serious harm to strictly defined human wellbeing, demand compression could target as much as 60%-75%.

• In Europe at least 33% cuts could easily be targeted without civil war and famine being in any way possible or probable.

Conversely, low income countries where per capita oil demand in rural areas can be well below 1 barrel/person per year cannot reasonably be expected to further compress their demand, to ease price pressures for the OECD North

No way out but restructuring

Current leaderships of the North will, this decade, learn that no amount of munitions and ordnance can solve or defeat the geological problem of oil depletion.

Some current leaderships of the North already produce ‘landmark speeches’ about the need to shift to renewable energy some time after 2050.

In fact, even by 2025, per capita oil use will be about 40%-50% down on today and the climate and environment consequences of continued high rates of fossil fuel burning will be impossible to deny.

Sooner, and not later, therefore, it will be understood that there are no military solutions to geological problems of fossil energy depletion. International cooperation, an almost forgotten term from the 1970s and early 1980s, when oil prices attained about $100/barrel in dollars of 2003, should rapidly be reinstated as the way forward to preparing all persons, both in the North and South, for a future in which at least two-thirds of our current and easily producible supplies of ‘conventional’ oil and gas will be exhausted by about 2035.

Andrew McKillop  is a former expert, policy and programming, Divn A - Policy, DG XVII-Energy, European Commission, founder member, Asian Chapter, Intl Assocn of Energy Economists. You may contact Mr. McKillop by email at andrewmckillop@onetel.net.uk