From the February 2008 issue of Research Magazine • Subscribe!

Ready for Cheap Oil?

The current trouble in global financial markets represents a correction in the overbought U.S. real estate market, but it is a more serious and broadly based problem -- which is why it so promptly impacted the financial services industry and sent officials in the world's leading central banks scrambling.

The real estate bubble is not limited to the United States, but impacts most markets around the world, from Wellington, New Zealand to Shanghai, China and London, England. Its deflation naturally began in a weak link -- the subprime segment of the U.S. market, among poor homeowners unable to service their mortgage debt. But it is now gradually spreading into other market segments in the United States and abroad. For example, sky-high house prices in London have already softened substantially since the subprime mortgage crisis in the U.S. broke a few months ago.

The Unifying ThemeHowever, the real estate bubble is only one of several bubbles that have appeared in the world economy since the start of this decade. Others include the stock market bubble, which has so inflated wealth that all 400 richest Americans on the Forbes list are now billionaires. This year, the 'poorest' member of this club was worth $1.3 billion -- $300 million more than in 2006. Since 2000, the United States has added 184 new billionaires.

Just as it is the case with the real estate bubble, the stock market bubble has not been limited to Wall Street but impacts other markets, especially emerging markets, to an even more extreme extent. A rally on the Mexico City bourse, for example, has turned Carlos Slim, the owner of telecom monopoly Telmex and various other Mexican companies, into the world's richest man.

Or take the art market, which has seen a painting by Andy Warhol, of all people, fetch $71 million at a recent auction.

Economists have been at pains to explain the price run-up in each of these markets. Real estate prices have been rising because the baby boom generation has matured and a new class of homeowners has been created thanks to easy, affordable mortgages. Fine art prices have been bid up because new museums are being set up all over China and the Middle East. Stock prices have risen because profit growth has been so strong.

In each individual case, these explanations are quite plausible. But when so many asset classes are hitting the stratosphere all at once, another factor is likely to be at work, namely the loss of value of money. Instead of a series of unrelated bubbles, the world economy is experiencing one general bubble -- the surfeit of liquidity.

Inflation has been defined, broadly, as the loss of value of money when measured in goods and services. Learning from the bitter experience of the 1970s, the U.S. Federal Reserve and other major central banks have been watching the consumer price index very closely. Until very recently, consumer price inflation has been negligible, allowing monetary authorities to keep their monetary policy relatively easy and short-term interest rates low. However, while the prices of generic goods and services included in the CPI have indeed been stable and even declining in nominal terms, because of intense international competition, money has still managed to lose value catastrophically. Inflation is now spreading into broader consumer prices as well, creating many of the very same problems that triggered economic stagnation in the 1970s.

Demand for OilThere has been a similarly believable explanation as to why commodity prices -- and oil prices in particular -- have shot up dramatically. It is China, and its over 1 billion consumers. China has come out of nowhere to become the world's second largest market for automobiles over the past few years, and coupled with rising industrial capacity at Chinese factories, China's demand for oil jumped from 4.8 million barrels per day (mbd) in 2000 to 7.3mbd in 2006.

This also took place against the background of a booming global economy. Since the end of the 2001-2002 global economic downturn there has been a strong rise in global demand for oil. Most nations, industrial and emerging ones alike, now consume more oil.

However, oil output also rose strongly over the same time period, with Russia alone now producing 3mbd more than it did in 2000. Russia is now the world's largest producer, on par with Saudi Arabia. Both of them are pumping around 10mbd. Most other producers have increased their oil production -- including, incidentally, China. Even if oil supplies have tightened since the end of the 1990s, when its price bottomed out at around $10 per barrel, it certainly doesn't justify the tenfold jump in oil prices we have seen in less than a decade.

A similar discrepancy between price and the supply-demand relationship exists in many other commodities markets. In fact, since oil is a bellwether for other commodities, it is safe to say that commodity markets have also been in a bubble stage, their prices rocketing mainly because of cheap and plentiful liquidity.

Should Know BetterToday, unlike the 1970s when oil was traded based on bilateral contracts, the bulk of the world's oil is sold today through the futures markets, where players are not users or producers of oil but speculators. They should be looking not so much at today's supply-demand relationship but at future trends in the market.

In all respects, the longer-term outlook for oil prices appears to be grim. There are greater reserves of oil in the world today than two decades ago. Reserves have been boosted by offshore finds as well as the inclusion of Canada's tar sands into its proven reserves. There are plentiful tar sands in many other countries and at $100 per barrel technology to extract it cleanly and efficiently is being rapidly developed.

In general, costly oil has been concentrating the minds of oil producers, producers of alternative energy sources and energy users wonderfully. For example, the recovery rate from existing reservoirs has nearly doubled as a result of new technologies. It remains at 35 percent, on average, providing plenty of room for further improvements in efficiency. Currently, tens of billions of dollars are being invested into new oil exploration and production, energy conservation and alternative energy sources.

This is the real reason why Saudi Arabia and other rich oil producers have always been afraid of costly oil and worked to prevent unsustainable run-up in oil prices. Having lived through the oil price boom of the 1970s, they know full well that it was back then when the seeds of the late 1990s bust were really sown. What they fear even more is that a protracted period of expensive oil could fundamentally alter the reality of global dependence on the stuff.

The way world markets have been moving, they have nothing to worry about. The real estate crisis seems to be but a start of a more general pricking of the world liquidity bubble. Once the U.S. Federal Reserve and other central banks tightened their monetary policies, this process was set into motion. Stock prices have been extremely volatile since mid-2007, and volatility has spread into the oil market. In a two-week period in late November, oil dropped by 15 percent in just a few trading sessions. This year may see a substantial decline in oil prices -- with dramatic consequences for profligate oil-producing nations who have assumed that the flood of petrodollars into their coffers will never dry up.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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