Over the past two decades the U.S. economy has gone through a series of bubbles that inflated for a while, creating real wealth for some and a sense of prosperity for others, and then burst, taking investors to the cleaners. If those bubbles were caused by easy money and lax oversight, as many economists believe, there is no reason to expect the outcome to be different in the future, especially since the United States now also runs a massive structural budget deficit.
What will be the next bubble to inflate and burst, then? Will it hit U.S. Treasuries, which after years of record prices have lost ground recently, with the yield on the 10-year bond going up to 3%? Or will it hit “undefaultable” student loans, of which the federal government holds over $1 trillion, adding more than $100 billion every year?
My own guess is that the next bubble will happen in oil. Oil prices reached a bubble stage briefly just before the financial crisis, coming close to $150 per barrel in mid-2008. It didn’t take long for prices to retreat, but the spike exacerbated problems in the housing market and the subsequent financial meltdown. Oil prices then plunged by 60% in eight months.
Emerging and Thirsty
Oil prices recovered quickly in 2009, largely because the Chinese economy continued to expand even as rich industrial economies went into a recession. Since 2008, the number of cars and trucks on Chinese roads jumped by a nearly 100 million, a stunning figure considering that the entire U.S. fleet comes up to 240 million motor vehicles. Industrial growth in China also created a boom in commodity producing economies such as Brazil, Australia and parts of Africa, all of which contributed to rising worldwide demand for oil.
Moreover, the dollar was weak throughout that period. Since oil is priced in dollars, stronger domestic currencies in many countries meant that local motorists were shielded from the impact of more expensive oil. Indiain particular enjoyed a boom in auto sales, in large part because the local currency, the rupee, was appreciating rapidly against the greenback.
Now many of the forces that stimulated oil consumption after 2009 have gone in reverse. The Chinese economy has slowed and, even if more recent figures point to a new acceleration, the government continues to discourage its people from buying and driving cars, given massive pollution and traffic congestion problems in the country’s major cities. Car ownership inChinais growing, but it’s no longer exploding. Meanwhile, the rapidly growing economies of India, Brazil and Russia—the other BRIC countries—have flagged and their currencies have weakened against the dollar in light of the imminent monetary policy tightening by the Federal Reserve.
One bright spot for the auto industry has been theUnited States, but rising U.S. auto sales are probably a net negative from the point of view of oil demand. The average car on the road in theU.S.is now 11.4 years old, a record. As Americans hit the showrooms, they merely replace their old clunkers with far more energy-efficient modern vehicles. If auto sales pick up inEurope, where they fell to a 20-year low earlier this year, the effect may be the same, cutting demand for gasoline rather than spurring it.
Persistently high oil prices over the past decade and a half have encouraged conservation efforts and prompted users to switch to less costly energy sources, especially to natural gas, which has become cheaper due to the fracking revolution. Since 1985, the measure of oil efficiency of theU.S.economy, the dollar amount of GDP it produces per barrel of oil, has increased by more than 50%. An indirect measure of energy efficiency is found in profit margins for S&P 500 companies: They have been hovering near their historic highs and now stand at 9.3%, despite high oil prices that should have theoretically boosted their costs.
The same factor that is prompting companies and consumers to use less oil—high price—has stimulated supply. Over the past 10 years, it has become economical to extract oil from shale and Canadian tar sands, and to invest in the development of costly deep-water drilling technologies. As time goes by, those technologies become more effective and less expensive.U.S.oil production is at a 22-year high, reaching 7.5 million barrels per day in July. The U.S. Energy Information Administration expects output to hit 8.2 million barrels per day next year. Largely as a result of new sources of oil coming on line, the International Energy Agency expects global oil supply to outstrip demand next year, raising the specter of a possible oil glut.
Nevertheless, oil prices spiked in August, flirting with their highest levels since 2008. The ostensible reason was tension overSyria, but even after the threat of aU.S.airstrike to punish the Syrian regime for use of chemical weapons abated in early September, oil traded at well over $100 per barrel.
A historical reference may help explain why oil is being pushed higher. During the Roaring 1920s, one of the worst speculative bubbles on Wall Street involved electric utilities. Investors decided (correctly) that the age of electricity had dawned, that every house would soon be filled with all kinds of electric appliances, that electricity would light streets and highways, etc. They snapped up the shares of utilities, neglecting the fact that utilities were highly regulated and were never going to reward their shareholders with the kind of fat dividends that their inflated prices implied.
Oil now mostly trades on futures markets and it has therefore become a financial instrument like those shares of utilities companies. Its price over the near term is governed by investor sentiment and driven by speculation. In the near term, ongoing political turmoil and sectarian violence in the Middle East have pushed oil prices higher, while over the longer term investors are concerned about “peak oil”—a notion that the world is running out of oil and that we are very close to (or have already reached) the peak of possible oil production on Earth. “Peak oil” suggests that from now on, while more and more emerging economies develop and build their own industrial base, demand for oil will continue to rise and supply will start inexorably to decline.
This theory is unproven and speculation that oil is running out has occurred before, notably after the Arab oil embargo in 1973. Concern about endemic oil shortages didn’t prevent oil prices from sliding during the 1980s and 1990s and eventually reaching a nadir of $10 per barrel, falling below pre-embargo levels in inflation-adjusted terms. Be that as it may, speculative demand currently is being stoked by such fears and, indeed, oiled by the plethora of cheap money provided by the Fed.
Oil prices may have just started to rise and—even if the war in Syria doesn’t worsen and spread to neighboring countries, notably oil-rich Iraq—could see another run-up to or above $150 per barrel before the end of the year. Even with less oil required to produce one dollar’s worth of global economic output, oil is still a crucial commodity, and a 30-50% spike in its price will deal a body blow to economic growth, just as it did in the 1970s and in 2008—especially since many emerging economies are already slowing.
High oil prices, meanwhile, will likely prompt the Fed to terminate its quantitative easing program sooner, and possibly even raise interest rates if costlier gasoline spurs consumer price inflation. Combined with the existing supply overhang, this could create a perfect storm, leading to another economic downturn and a subsequent dramatic deflation of the oil bubble.