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Falling asleep at the wheel – will rising oil stamp out the green shoots of recovery?

By 29th June 2009June 16th, 2023No Comments

Falling asleep at the wheel – will rising oil stamp out the green shoots of recovery?

Oil prices ranged from $40 to $140 in 2008 and averaged well above $90 per barrel. Late last year, the World Bank, the IEA and US Department of Energy all predicted a collapse in oil demand, because, in the words of the World Bank, the world faced “the worst recession since the Great Depression”.

Oil subsequently fell to nearly $30 US a barrel in late December, and at the beginning of ‘09 the majority of institutional analysts predicted that prices would meander around the $50 dollar mark for the year.

The markets have unfortunately refused to cooperate. Prices have been creeping upward and seem to have topped out for the moment at around $70 per barrel. In other words, the cost of oil has more than doubled since the beginning of the year. It seems strange that oil should be so high at a time of weak demand and apparently abundant supply.

A rising oil price combined with deep recession causes sleepless nights for economists, and for good reason.

Oil price really matters. As pointed out by Liam Halligan, Chief Economist at Prosperity Capital Management, the difference between oil price this year and last has already yielded a windfall for the major Western economies (all oil importers), of over $1,600bn, which is “more than the heralded fiscal stimulus packages announced by the UK, US and Eurozone for this year and next”.

If oil were to continue its march north, the effect would be to cancel out all of the positive consequences of the global fiscal stimulus and jackboot the long-sought green shoots of recovery. The possibility of a deep recession combined with high prices could breath life into the corpse of “stagflation” – a phenomenon that has not stalked the global economy since the early ‘80s.

But it is not just the upward trajectory of oil prices that causes sleepless nights –  volatility also wreaks havoc. According to Royal Dutch Shell CEO Jeroen van der Veer, speaking recently at a conference in Abu Dabhi, “If the oil prices stay volatile I’m afraid there will be too much slowdown in investment“.  This would, he predicts, lead to another spike in prices because volatility makes it extremely risky for investors to make medium to long-term commitments.

All of this begs two billion (or, more likely “trillion”) dollar questions: what is driving the recent trend on price and how worried should we be about future prospects for this vital commodity?

It is widely acknowledged that short-term considerations are a factor in recent developments. A weaker dollar and increasing financial market activity are certainly playing a role.  The greenback has dropped 9% against a basket of currencies since March and because oil is priced in dollars the real price for those with stronger currencies is mitigated.

In the second case, increased market activity has led to a general commodity price rally. This is, according to the Economist magazine, because “there is hope that the world financial system has escaped collapse and that global growth may improve soon”. It seems that investors are breathing a sigh of relief and playing the markets with the cash that had been stashed under the mattress since the collapse of Lehman Brothers.

Consumption it is argued will indeed remain 2.5 million barrels lower in 2009 than 2008, leaving quite a space between strong supply and weak demand.  From this perspective it is those pesky investors up to their old tricks again and non-fundamental issues are largely accountable. If that’s the case, surely the world can gently relax back into its complacent slumber?

Well thank God for that! Except unfortunately there may be a couple of problems with this analysis if we take a somewhat longer perspective, which is perhaps what some investors have been doing.

First, according to BP’s Statistical Review of World Energy (pdf), published in June 2009, the world reached a notable milestone in 2008, in that “non-OECD primary energy consumption exceeded OECD consumption for the first time”. What this means is that the OECD can enter recession, but strong demand elsewhere, especially the BRICs, will compensate, even in the teeth of “the worst recession since the great depression”.

What of the supply side? We already know that investors are having difficulty tapping existing reserves – the IEA expects a 21% drop in oil and gas investment budgets in 2009 compared to 2008.

And the other boogie man – finite reserves? Not to worry on this count at least it seems. According to a leader of Saudi Arabia’s oil industry, Abdallah Jum’ah, who stepped down last year as chief executive of the Saudi Arabian state-owned oil company “the world’s endowment (including unconventional sources such as tar sands) is estimated at 15 trillion barrels. Even after more than a century of widespread use, we have consumed only 1 trillion barrels.”

His comments are echoed somewhat less bullishly by Tim Hayward, Group Chief Executive of BP, in the forward to the Statistical Review. He argues that “the challenges the world faces in growing supplies to meet future demand are not below ground, they are above ground. They are human, not geological”.

Not everyone agrees. Chris Skrebowski, consulting editor of Petroleum Review, predicts that global oil production will peak (pdf) in the period 2011-2013 and then decline steadily and outlines several reasons to be cautious about reported reserves.

Even those who suggest abundant supply acknowledge that production outside OPEC has already peaked, leaving existing supply concentrated in volatile regions of the world. ?

So perhaps one way to interpret recent trends is to acknowledge that investors are not making decisions in a vacuum. They do bring real information to prices. While other factors are certainly at play, price at historically high levels in a time of deep recession should be causing sleepless nights, and not just for the economists.