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Roiled By Oil

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Conventional wisdom suggests that oil prices increased eightfold, from less than $10 per barrel in 1999 to a peak of $77 per barrel in mid-2006, because of a sharp rise in global demand. This is probably not true — or at least it is not the whole story. There are other, more ominous forces at play in global oil markets, as well as in non-oil commodities.

To be sure, oil demand did rise, especially in China, which now burns some 7 million barrels per day (mbd), the second largest amount after the United States, and accounts for about 8.5 percent of global oil consumption. Other Asian countries, including India, the world’s second largest country in terms of population, have also been growing rapidly in this decade, and consuming more oil as they develop. Demand from Asia contributed some 40 percent to 50 percent of the global increase in oil demand over the past seven years.

Since 1999, global oil demand has grown by a little over 10 percent, or by some 8mbd. However, oil production kept pace with rising demand, as more oil has been teased out of the ground by higher prices. High oil prices encouraged investment into new production in most oil-producing regions. The former Soviet Union, for instance, boosted its output by 55 percent, or 4mbd, over this time period. Canada’s tar sands are expected to increase output from zero to 10mbd over the next two decades. Once investment in such new exploration and production is made, it is hard to curb output even when oil prices fall. There is more than enough supply coming to market to satisfy projected global demand growth through 2030.

Interestingly, in the four-year period between 1995 and 1999, oil consumption grew by nearly 10 percent — no slower than in the 1999-2006 period. Yet, oil prices kept falling steadily, despite strong demand growth.

A Dog That Didn’t Bark

This is why the run-up in oil prices took analysts by surprise. Early in this decade, only alarmists forecast $40-per-barrel oil by around 2007. Now, many economists expect excess supply to drive oil prices down again. Yet, oil remains expensive.

While crude prices increased by such spectacular margins, and U.S. gasoline prices nearly tripled, oil stocks have remained remarkably unresponsive. The share price of Exxon-Mobil (XOM), the industry’s flagship, roughly doubled since 1999, but this was hardly a standout performance on the Big Board. Even though Exxon-Mobil has been posting eye-popping profits, its stock has been trading at a lackluster price to earnings ratio of around 10. The Dow Jones index of U.S. integrated oil and gas companies has doubled since the U.S. stock market hit a nadir in 2002, but once again the sector has not been the standout performer one would expect it to be under the circumstances.

The problem is that the oil market is not really free. Most oil reserves are owned by national governments, many of them unstable or uncooperative. Only about 15mbd — or 75 percent of U.S. consumption — is pumped in the Western world. Proven reserves owned by the large oil multinationals are dwarfed by what state-controlled companies, such as Saudi Arabia’s Aramco, Venezuela’s PDVSA and Mexico’s Pemex possess. Politics, not laws of supply and demand, drive oil prices over the longer term.

The overriding reason why oil prices have been so high in recent years is a dramatic weakening of the United States, the chief guarantor of global stability. Its weakening has been all the more surprising since a few years ago America was the world’s only superpower. However, since 1999 lots of things have changed — mainly for the worse. The formidable U.S. armed forces have been fought to a virtual standstill by semi-feudal militias — so much so that the United States can no longer readily project its military power elsewhere. Whatever the merits of its international policies, Washington has become so thoroughly disliked and distrusted around the world that it simply can no longer inspire or lead.

These are political concerns, but there are economic vulnerabilities as well. The United States is now the world’s largest debtor. It needs $800 billion in annual capital inflows to balance its trade account. It relies on the willingness of foreign central banks to hold dollars and U.S. Treasuries in order to prevent the collapse of the greenback and the U.S. bond market. Its industry has been hollowed out and its consumers have become hooked on cheap imports from China, a former arch-enemy. Not that Beijing’s Communist rulers could blackmail Washington. The problem is that when the Chinese people start demanding more democracy and less meddling from Party bureaucrats — something the United States hoped they would do throughout the post-World War II decades — the resultant economic turmoil will deal a severe blow to the U.S. economy.

Back to the 1970s

Expensive oil, in fact, goes hand in hand with a weak dollar, the international reserve currency. Investors no longer trust in America’s ability to hold the world economic and financial system together — which is the reason why gold, the primordial store of value, doubled in price earlier this year and still fetches nearly $600 per Troy ounce.

Most economists view high commodity prices as a sign of market optimism and a harbinger of robust global economic growth. In fact, expensive oil and non-oil commodities probably presage economic, political and military turmoil. Historically, periods of strong economic growth — such as 1950-1970 and 1982-2000 — were accompanied by steady, and generally low, commodity prices, whereas high prices in the early 1970s ushered in a decade of drift and stagnation.

In fact, today’s market conditions — expensive commodities and gold and a falling dollar — mirror the 1970s, when America lost its ability and desire to lead in the aftermath of the Vietnam war.

However, back then America’s weakness meant Soviet strength, a condition that concentrated the minds of its allies and kept them in line. No such imperative exists today, as a rift with Western Europe indicates.

Prepare for the Worst

America will probably right itself. There is no other power on the horizon that could wrest leadership from Washington or provide the same degree of security, stability and prosperity as the current global economic system. Nevertheless, it may be a difficult slog. Commodity prices in general, and oil prices in particular, eased in September and October, with oil dropping around 25 percent from its July highs. The dollar also traded at its highest level in months against the euro and the yen, confirming our analysis that commodity prices, and especially oil, track investor perceptions of American strength, rather than global supply and demand dynamics.

However, if this analysis is correct, it will be a temporary decline. Oil prices — and other commodities such as metals and agricultural raw materials — will spike once again before long and are likely to remain elevated for the remainder of the decade.

This is not as bad as may appear at first glance. First of all, the past six years have shown that even a dramatic run-up in oil prices doesn’t lead to an inflationary spike in an environment of stiff international competition. A competitive market environment is a major difference between today and the 1970s, when producers had little difficulty passing their higher costs on to their customers, thereby unleashing an inflationary chain reaction. Now, life-and-death struggles for market share preclude such easy price increases.

Second, high commodity prices could help create a fundamentally more energy- and raw materials-efficient economic environment. Savvy investors should back alternative energy sources and new technologies that help reduce the use of oil, gas, metals and other commodities. This is likely to be a new frontier in the on-going technological revolution.

Alexei Baye r runs KAFAN FX Information Services, an economic consulting firm in New York; reach him [email protected] .


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