Jeff Rubin: Triple Digit Oil This Quarter

Jeff Rubin was the first mainstream economist that I recall warning us that $100 oil was only a few years away. That was shortly after the year 2000 when talk of $100 oil made everyone think that you wore a tinfoil hat around your house.

Of course Rubin was correct. He had discovered the writing of Colin Campbell which convinced him that the world was getting to the point of maximum daily oil production.

In case you hadn’t noticed the 75% of the world that doesn’t use WTI as the benchmark for oil prices is again paying near $100 per barrel.

I thought it would be a good time to check in on Rubin who has written the following articles within the past month:

[www.jeffrubinssmallerworld.com]

How Do Oil Shocks Cause Recessions?

There are many ways that oil shocks affect the economy, and none of them is good. As the prices of gasoline, diesel and home heating fuel rise, consumers’ energy bills eat up a growing share of their after-tax income, forcing cutbacks in more discretionary areas of spending. The next thing you know, people are going out to restaurants a lot less, taking fewer vacations and buying fewer clothes.

Soaring oil prices also transfer billions of dollars of income from oil-consuming economies to oil-producing economies. Nearly one trillion dollars migrated from OECD economies to OPEC ones in the record run-up of oil prices preceding the last recession. Since savings rates in countries like Saudi Arabia, UAE and Kuwait are typically ten times what they are in major oil-consuming economies like the United States or Western Europe, the shift in purchasing power resulted in weaker global demand.

But by far the greatest impact that oil price shocks have on the global economy is the one they make on inflation and, hence, interest rates. This linkage is the means by which they have typically delivered a mortal blow to economic growth. Oil shocks have always given rise to growth-ending increases in interest rates as central banks are forced to respond to the inflationary fallout they leave behind.

The last recession was no exception. As oil prices soared from $35 per barrel in early 2004 to almost $150 per barrel in the summer of 2008, consumer price inflation in the US tripled to a rate of almost six per cent. It didn’t take long before interest rates caught up to inflation and, in the process, blew up the massively over-leveraged subprime mortgage market and the economy with it.

But lest we’d forgotten, it was the massive rise in energy inflation, and an associated rise in food prices (more on that in future posts), that catapulted the Federal Reserve Board’s federal funds rate from a nurturing one per cent setting in early 2004 to a level over five times that only a couple of years later. The rate of energy inflation rose from less than one per cent to as high as 35 per cent.

Oil prices caused the last recession, and oil prices will cause the next one as well. Energy inflation is already on the march. In fact, this time around oil prices are rising much earlier and much more rapidly than they did last cycle. Inflation is already running at nearly a five per cent rate in China; as oil prices go on to set new record highs, it’s only a matter of time of before we see those inflation rates in North America and in the rest of the OECD.

And when we do, get ready for another oil-induced global recession.

How Sustainable Is Growth with Triple-Digit Oil Prices?

With oil prices within spitting distance of triple-digit levels (Brent traded over $99 per barrel last week, while West Texas Intermediate was north of $90 per barrel), it may be time to reconsider just how long this recovery will run.

The fact that we’re seeing oil at triple-digit prices in this cycle should come as no surprise. After all, that’s where oil prices ended up last cycle before deep-sixing the global economy. But to see triple-digit prices again this early into what by all historical standards has been a painfully slow global recovery must be disconcerting to a world economy never hungrier for growth.

If merely getting back to pre-recession levels of global industrial production has oil knocking at the gates of triple digits, where do you think crude will be trading should we be fortunate enough to sustain this economic recovery for another year?

If anyone doubts how vital oil is to economic growth, just look at what happened last year. Global oil demand grew at two and a half per cent from the year before (almost double the International Energy Agency’s original forecast for 2010). China alone added almost one million barrels per day to its daily petroleum diet. Should demand grow by another two to two and a half per cent this year, crude prices could easily be taking out last cycle’s high of $147 per barrel. And if the speculators jump on the bandwagon, the forecast I made three years ago for $200-per-barrel oil prices in 2012 may yet pan out, the recession of 2009 notwithstanding.

But where would that leave the global economy? While economists may not formally consider oil as a factor of production, oil and economic growth are inextricably linked. In a world where conventional oil production hasn’t grown in over half a decade, that connection means that continued economic expansion can only be at ever-increasing wellhead costs and ever-higher crude prices, provided, of course, that soaring oil prices don’t do what they have always done before—cause major recessions in oil-powered economies.

Every major global recession over the last forty years has had oil’s fingerprints all over it. The first OPEC oil shock led to a devastating recession in 1973, only to be followed by the double-dip recessions on the heels of the second OPEC shock. When Saddam Hussein invaded Iraq and lit its oil fields on fire, pushing oil up to the then unheard-of high of $40 per barrel, once again recession quickly ensued. And of course, when oil prices surged to a record-high $147 per barrel, the deepest post-war recession ever followed close behind.

So why should we expect our next rendez-vous with those prices to yield any different results?

Is There Enough Oil to Pay Our Debt?

2010 left us all with a mountain of debt. Whether you’re a taxpayer in the UK, Ireland or the US, it must already be pretty clear that you’re on the hook for a lot of IOUs borrowed from your future. You may not have borrowed the money yourself, but your government has already done it on your behalf, running up massive, record-setting deficits. What’s not clear is exactly how your government is going to pay that debt back.

With students already rioting in London over huge tuition increases, and general strikes the order of the day in places like Athens and Madrid, chances are slim that incumbent governments will survive long enough to cut their way to fiscal solvency. That’s not to say the fiscal brakes aren’t on (they are—at least everywhere but in the US). But the deficits are so gargantuan (as an example, Ireland’s is equal to one third of the country’s GDP) that the twin tasks of slashing spending and hiking taxes could last decades, provoking all kinds of social and political push-back during that time.

Given austerity’s slim chance at success, you might ask why government borrowing rates in the bond market, though rising, aren’t much higher. History would suggest that the yield on a ten-year US Treasury bond should be close to double what it is, given the size of Washington’s borrowing program.

The reason it’s not is that creditors and debtors both share a common belief that a powerful economic recovery lies just around the corner—one so powerful, in fact, that tax revenues will suddenly fill government coffers and let bondholders be paid the huge sums they are owed while at the same time sparing taxpayers an otherwise draconian fate.

The only problem is that the economic growth everyone is counting on is powered by oil. And as you’ve probably noticed, that’s getting more and more expensive to burn.

The minute global industrial production recovered from the recession, oil prices were suddenly on the verge of triple digits. That’s not an accident, since the two go hand in hand. Global oil demand is up 2.5 million barrels per day from last year. Any further increases in oil demand and oil prices will be trading comfortably in triple-digit range.

That suddenly makes all that government debt very energy intensive. It will take huge amounts of energy, particularly oil, to achieve the growth rates that all the near-bankrupt governments around the world need to even service their debt, let alone repay it.

So consider just how sustainable economic growth would be in a world of oil prices of $100 to $225 per barrel. Because those are the price parameters we’d be facing in the unlikely event that we actually see the kind of economic growth that bond markets and public treasuries around the world are so desperately depending on.

Will Car Sales Ever Rebound to Meet US Ethanol Targets?

Just as the fiscal crisis sweeping through the major oil-consuming nations of the world is cutting funding for green energy, one of the most expensive yet least efficient of green fuels, corn-based ethanol, has been given another year of generous taxpayer support in the US.

The promotion of corn-based ethanol has been America’s principal policy response to its growing dependence on ever more costly foreign oil. Fuelled by a federal tax credit of 45 cents per gallon and a crippling 54 cent per gallon tariff against competing Brazilian sugar-based ethanol, American ethanol production has grown exponentially over the course of the last decade to around 12 billion gallons per year in 2010. And it’s targeted to grow to as much as 36 billion gallons by 2022. Food inflation, particularly with respect to corn prices, has moved in step. Thanks in large measure to ethanol demand, US corn prices are up some 40 per cent this year.

Food inflation aside, Congress had lots of other good reasons not to extend further subsidies. The net energy content from ethanol, after allowing for all the hydrocarbon inputs (ranging from fertilizers to diesel fuel for the tractors to coal for the processing plants), is marginal at best. And its carbon footprint isn’t materially better than burning fossil fuels, given how much of the latter is embodied in its very production.

Despite a last-ditch attempt by Senator Dianne Feinstein and others to end the subsidies, the Senate decided to fork out more pork barrel funds to corn farmers and, by extension, to firms like Monsanto and Archer Daniels Midland for another year.

But don’t count on American ethanol production’s ever coming even close to reaching that lofty target of 36 billion gallons per year. If the return of fiscal sanity to Washington doesn’t undercut its life-sustaining subsidies, an aborted recovery in motor vehicle sales will soon put the kibosh on future production growth.

Car manufacturers and ethanol producers both hope that an economic recovery will return vehicle sales to their pre-recession levels. Unfortunately, the recovery they are counting on so heavily is a double-edged sword.

An economic rebound will very quickly push pump prices beyond most drivers’ reach. They’re already hovering around $3 per gallon, and with triple-digit oil prices around the corner, we’re sure to see prices of $4 per gallon or higher by next spring.

The last time we saw those prices, in the summer of 2008, scooters were outselling SUVs by a margin of three to one, and no one was keen to scoop up car-leasing firms and make acquisitions like Toronto-Dominion Bank’s recent $6.3 billion purchase of Chrysler Financial. Four-dollar gas crunched the North American vehicle market back in 2008, and it will likely do the same in 2011.

And when it does, American farmers can go back to growing corn for food and, in the process, save taxpayers some $7 billion a year in ill-conceived ethanol subsidies.

EIA’s Forecast Is an Energy Fantasy Land

The recently released base case that will be used in the upcoming Annual Energy Outlook 2011 from the US Department of Energy’s Energy Information Administration (EIA) paints a future of cheap and abundant energy for the US economy over the next quarter of a century. But its underlying assumptions are no more credible than those that underpinned the equally optimistic forecasts released by the International Energy Agency.

In the EIA base case, electricity prices in the US are basically flat for the next two and a half decades, thanks to cheap natural gas, while oil prices don’t even get close to their 2008 peaks until way off in 2035.

To top it all off, despite this new world of cheap energy, carbon emissions in the US economy don’t grow. (Since the EIA is counting on no less than 5 million barrels per day from the Alberta tar sands, the same cannot be said for the Canadian economy.) American emissions remain below their 2005 peak until 2027, even though no caps or trade policies are assumed to exist, and even when the agency is forecasting an almost 30 per cent increase in national coal consumption over the period.

With fossil-fuel energy abundant, and carbon emissions remarkably self-contained, the forward-looking EIA expects only a marginal increase in the contribution from renewables, whose very viability is challenged in the absence of public subsidies.

A doubling in estimates of shale gas reserves drives much of the energy abundance the EIA predicts. Whether shale gas turns out to be the game-changer the agency claims or the gas industry’s version of the subprime mortgage market will ultimately depend on where its true cost curve lies.

If it’s really in the neighborhood of $4 per 1000 cubic feet (Mcf) then there is enough gas to keep the lights on in America for years. But if the true cost curve lies closer to $8 per Mcf (even before environmental costs like local groundwater contamination are factored in), then gas may not be as abundant as the EIA believes, and long-run electricity prices may not be nearly as cheap as forecast.

Either way, as I noted months ago in my post about Boone Pickens’ plan, shale gas doesn’t address the emerging shortage of the liquid fuel that is needed to power the 250 million vehicles or so that run on US roadways.

Which bring us to the EIA’s oil price forecast. Measured in today’s dollars, the agency doesn’t see oil getting to $125 a barrel until 2035. The $125-per-barrel oil price that the EIA has spotted on the very distant 25-year horizon, I believe, will actually be staring the agency in the face within the next twelve months. I leave it to others to assess what that will imply for the credibility of the rest of the EIA’s outlook.

Triple-Digit Oil Prices Back Within a Quarter

The strongest manufacturing numbers coming out of the Chinese economy in a seven-month period, coupled with plunging oil inventories in the world’s largest energy consuming economy, have sent oil prices to a 25-month high. With no let-up in China’s fuel demand, the world should be looking at triple-digit oil prices again within a quarter.

That may come as a shock to those who thought the bloated oil inventories that came in the wake of the last recession would provide a buffer against future oil price spikes. Suddenly that buffer has literally gone up in smoke.

Refined oil stocks held by China’s two largest oil companies have fallen for eight consecutive months, while diesel stocks in the country fell 14 per cent in October. And the tightening oil market won’t just be felt in China. The 140 million gallons of international oil inventories sloshing around in floating storage on the high seas is also all but gone.

With oil prices within striking distance of triple-digit levels, don’t look for any price relief at the upcoming OPEC meeting in Ecuador. Venezuelan energy and oil minister Rafael Ramirez was recently quoted as saying that $100 per barrel was a fair price for both consumers and producers. (But not for cab drivers in Caracas, who will continue to be able to purchase their fuel at $20 per gallon, the equivalent of a little over $8 per barrel). Meanwhile, King Abdullah of Saudi Arabia has already served notice that, without triple-digit prices, there is little incentive for new oil exploration in his kingdom.

In other words, without the return of the kinds of oil prices that put the world economy into the deepest ever post-war recession, we shouldn’t expect major oil producing countries to find and develop new supply. Yet according to the recently released World Energy Outlook from the International Energy Agency (IEA), world oil demand has never been more dependent on finding new supply.

How the goal posts have moved when it comes to oil prices and supply forecasts. Just as the IEA has finally recognized the reality of peak oil—at least insofar as affordable conventional oil is concerned—triple-digit oil prices have become the new normal in OPEC’s price expectations.

When both OPEC, an organization representing 40 per cent of world oil production, and the IEA, representing countries that consume roughly 50 per cent of the world’s oil, both now acknowledge the imminent return of triple-digit oil prices, perhaps it’s time our policy-makers should as well.

Our last encounter with those prices was brief but decisive. Oil demand collapsed, and, since oil powers our economy, so did GDP. What steps we have taken to ensure the same thing doesn’t happen again is far from clear.

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