Cost of oil poses problems for the economy again

By: Shawkat Hammoudeh

Posted: 7/3/09

Oil prices exceeded $147 a barrel on July 11, 2008. Before that, Goldman Sachs predicted that oil prices would reach $200 a barrel. But it did not. In fact, it dropped to close to $32 in mid January 2009 and some predicted that the price would go as low as $25 a barrel. But once again, it did not.

The world has forgotten Goldman Sachs' prediction and instead concentrated on the collapse. As a reminder of the underlying strength in oil markets, I posted on December 16, 2006 in the middle of the doom and gloom, an Op-Ed conjecturing an oil market resolution for 2009. I stated that I "believe oil price should be above $50 a barrel and should target $70 near the end of 2009." I added "The lowering risk and increasing risk appetite process should also be accompanied or preceded by improving stock market ….. The oil market should gallop behind the stock market. Thus, the stock market will be on the side of the oil market in 2009." On February 22, 2009, I posted another Op-Ed reminding those interested in the oil price that there are forces in the gasoline market working for the oil price to make a comeback.

While some once thought that the prediction of $70 oil was na've thinking, there are others now who think that the idea of an oil price reaching $200 a barrel in the foreseeable future is highly imaginative. Putting politics, economics and technology aside, let us first look at it from a philosophical point of view. The march of the oil prices to $147 a barrel - and most likely even more later - is part of the survival of the planet which has gone through forces of destruction such as wars, famines and epidemics but managed to survive The swine flu is part of those forces. The planet unleashes these evolutionary forces to ensure its survival. Based on this philosophical thinking, forcefully blocking out those forces will not be successful. This may be a reminder to President Obama who wants to discuss oil prices with the Saudis.

The collapse of the oil price may be considered a sudden block to those forces that were generated by man-made events such as the credit crisis, regardless of who is behind them. But the collapse has generated counter forces that again lead to higher oil prices to ensure the survival of the planet. One of these forces is the postponement and cancellation of oil investment projects. This can be considered destructive to current and future oil supply. According to International Energy Agency, $170 billion dollars worth of oil projects have been either postponed or cancelled. This amounts to a delay in additional future production capacity that is equivalent to 6.2 million barrels a day. The Organization of the Petroleum Exporting Countries itself reports delays of more than 35 of some 150 planned upstream projects, with some deferred until after 2013.

Exploration opportunities have also been on the decline for the last 40 years. There is now a renewed interest in exploring for oil in the Arctic which is the most difficult and most expensive area on the surface of the earth to extract oil from. The marginal cost for this area would be much higher than the current cost of extracting the marginal oil in the difficult areas of deep waters which ranges $60 to $80 a barrel. This means the current oil prices are well justified and the era of cheap oil is gone, even when the world economy is going through a great recession like now. A corollary to low exploration is heavy depletion in many mature oil fields. There is natural depletion in oil fields in Angola, Brazil, Nigeria, the North Sea, Mexico, Russia and others. The rate could reach nine percent per year if no new discoveries are added and no investments are made, according to IEA.

On the production side, non-PEC production increases at an anemic rate at best, if at all. In Mexico, for example, oil production declined by nine percent, and some of its major fields dropped by 30 percent, year after year. The decline of Cantarell, one of the four "super-giant" oil fields in the world, has accelerated to 38 percent per year. At the current rate, Mexico's oil exports will cease altogether in seven years or less. There are also the forces of potential supply destruction which are now working underneath the surface. There have been global shut-ins in small oil fields which do break even at $40 a barrel. The shut-ins increase as the oil price decreases.

On the inventory side, we witness the start of supply destruction in the form of declines in crude stocks, both at sea and on land. The IEA reports that global floating oil storage at sea dropped to about 80 million barrels at the end of May, the equivalent of about one million barrels per day over that month. The Department of Energy/Energy Information Administration also reported that the U.S. oil stocks on land dropped significantly.

The oil price and its supply and demand fundamentals are coincident indicators. At certain times, particularly when the world economy is reaching a turning point, the oil price looks up to leading indicators such as the stock market and divorces itself from its fundamentals to seek the road ahead. The stock market and six others out of the United States' 10 leading indicators have signaled that the recovery is not too far from here. The Deutsche Bank estimates that the positive relationship between the S&P 500 index and the oil price is $7 per barrel for every 50 point-increase in the S&P 500 index. This relationship increases significantly when the speculators become active as they are these days. Thus, the oil price has put aside its current supply and demand fundamentals and started to rely on the leading indicators as precursors of future fundamentals. Speculators have detected this change and helped move the oil price further up.

As I predicted in my most recent post of the U.S. recovery, the U.S. economy is expected to go back to positive GDP growth in the fourth quarter of 2009. This recovery will first be tepid but will gain strength to yield an economic growth between 2.5 percent to 3 percent around 2012. A U.S. economic recovery and expansion should help breed and strengthen other recoveries around the globe. On the other hand, it is more likely China will start its recovery before the U.S. and reach 10 percent to 12 percent GDP growth circa 2012. India is now achieving more than 5 percent economic growth and should return to 8 percent or more by 2012.

Relating this global growth prospect to oil demand, it is likely that we will have a strong demand growth for oil that eventually amounts to more than 2.5 percent per year around 2012. If we measure the cumulative increase in demand by 2012, we should have a demand for oil that reaches more than 90 million barrels per day, up from its current level of about 83.3 barrels per day. When this sizable oil demand is compared to the available supply at that time, we should have a tight balance between supply and demand in which the marginal oil matters considerably. This would be a fertile environment for speculators to push the oil price much higher than what the 2012 fundamentals warrant. Again, we will have another unhappy divorce between the oil price and its fundamentals. Two hundred dollars per barrel should again appear in the radar screens of the speculators. Such a high oil price will have enormous political, economic, and cultural repercussions on the world and on the oil producers in particular. Many economic and political scenarios can be reassessed in terms of this highly probable oil price outcome.

Shawkat Hammoudeh is a professor of economics. He can be reached at op-ed@thetriangle.org.