By John Richardson
WE worry that quite a few people still don’t get it on crude oil.
Here is why:
- As recently as July, as the chart above from the latest BP Energy Review shows, oil prices were from 2009 until July of last year were close to costing 5% of global GDP. At this level, they had always, in the past, caused US recessions.
- The only reason why oil prices had not caused a global economic crisis, up until July of this year, was because of all the misplaced central bank government stimulus.
- In China, the biggest economic stimulus package the world has ever seen for a country of its sized cushioned the global impact of oil prices in numerous ways. For example, the global autos industry was bolstered by sales in China, which grew by 138% between the end of 2008 and October of last year. Yes, this is not a typo – 138%.
- And in the US, the Fed’s quantitative easing programme also helped to cushion the impact of higher crude prices.
- The trouble is that, if you view the world economy as a living room sofa, this “cushion” only filled a very small corner of that sofa.
- Why? Because China’s “wealth effect” from all that stimulus benefited very few people locally.
- And in the West, whilst chemicals and other companies were flush with cash from the “China boom”, average working people were being squeezed by higher gasoline, diesel and other oil product prices.
- This was the result of the stagnation of middle class incomes in the US as real jobs growth failed to recover.
- And in the Eurozone, all the signs have been there for several years that the region would slip into deflation. This is now happening. How can oil prices that cost 5% out of global GDP possibly be sustainable when you have youth unemployment in Italy at an all-time record high of 44.2%?
But we were told everything was fine by those with a vested interest in keeping oil prices high.
They kept telling us that the rise of the “middle classes” in China and elsewhere in the emerging world meant that “this time was different” – i.e. we could ignore economic history.
We were told, again and again, that because most people were becoming so much richer than had ever been the case before, especially in the emerging world, oil well in excess of $100 a barrel was not a problem.
This conveniently ignored facts such as the following:
- Average per capita urban incomes in 2013 were just Yuan 29547 ($4769) in China, according to official government statistics.
- China’s average per capita rural incomes were only $1276.
- After adjusting for inflation, US median household income in 2013 was 8% lower than it was before the recession, 9% lower than at its peak in 1999, and essentially unchanged since the end of the Reagan administration.
- In the UK, If the national minimum wage had kept pace with FTSE 100 CEO salaries since 1999, it would now be £18.89 per hour instead of £6.50.
The people who told us that it didn’t matter that oil was costing around 5% of GDP were the same people who had gone almost permanently long on crude, other commodities and equities. All of these asset classes increased together in virtual lockstep because of “correlation trading”.
These same people, the financial players, of course, were behind these following startling statistics:
- In 2005, world oil production was 82 million barrels a day of crude, with WTI hedging on the NYMEX at less than 1 million barrels a day..
- By 2011, world oil production was still only 84 million barrels a day. However, WTI hedging was now half of the total.
- In 2005, just 920,636 contracts were traded in the US NYMEX WTI futures market.
- By 2008, this had risen to 21,485,557 contracts.
- And in 2011, 41,943,006 contracts were traded.
The problem is that some chemicals and other companies laid off their research departments.
They, in effect, outsourced their analysis of oil markets to the financial players who had an interest in maintaining the illusion that oil markets would remain in a virtual permanent contango.
The reason for outsourcing research was that too many people were convinced we had entered an era of permanently higher and more stable prices.
But we now know that this was a “false calm” created by central bank stimulus.
This stimulus is now being withdrawn in China.
This will have huge consequences for the affordability of oil, and all the things made from oil in China, now that the “wealth effect” of excessive credit creation has come to an end.
China is also learning to do “more with less” for cost saving and environmental reasons. This will further effect the demand for crude imports.
And for geopolitical reasons, China wants to be more hydrocarbons self-sufficient, which will, of course, further dampen the growth in oil imports.
The Fed is, at the same time, withdrawing its stimulus as the Eurozone flounders for policy solutions to its dilemmas.
Unless or until the West accepts that demographics are at the core of its problems, politicians will fail to come up with the right solutions.
Some people are , meanwhile, wishing that oil prices will recover on OPEC production cutbacks and the shutdown of higher cost production elsewhere.
They might be right, but for the wrong reasons, as we think that there is a very good chance that:
- Saudi Arabia, the world’s most important “swing producer”, may not cut back production anytime soon. This is because it has to try and push prices low enough to force the permanent closure of higher cost US shale-oil production. This would help maintain the US political and military support that it still needs (we will look in more detail at Saudi Arabia’s dilemma, and the rest of OPEC, in a later post).
- The break-even for US shale oil production might be below $40 a barrel, and so prices would have to go a good deal lower yet before Saudi Arabia achieves its objectives.
Why these people might be right for the wrong reasons is that now that the “false calm” of central bank stimulus is over, real price discovery has returned to oil markets.
Real, as opposed to fabricated, supply and demand issues are going to matter much much more.
So are geopolitics. Oil markets, from now on, will fully reflect every geopolitical crisis.
The suspension has, in effect, been removed from oil markets. As a result, we are going to feel every bump on the road.
It is perfectly possible, therefore, that oil prices will fall by another $25 a barrel by the end of this year – or recover to more than $100 a barrel on, say, Russia cutting off gas supplies to Europe this winter.
Obviously, some people will be celebrating at the higher end of this range. These will be the financial speculators who are still long on crude.
But for chemicals and other companies that sell most of their products to people on average incomes, we have this final message:
BE CAREFUL WHAT YOU WISH FOR, AS THE GLOBAL ECONOMY CANNOT SUSTAIN A RETURN TO OIL PRICES IN EXCESS OF $100 A BARREL.