Time to do something about oil by Martin Hutchinson

THE BEAR'S LAIR
Time to do something about oil
By Martin Hutchinson

The oil price rise of more than US$50 per barrel since the US Federal Reserve started cutting interest rates in September is beginning to get serious. Since the rise of oil import prices alone removes $170 billion from the US economy, more than 1% of gross domestic product, it is both inflationary and highly recession-producing, especially since it has been accompanied by similar rises in other commodity prices. Its full effects have not been seen yet but they're coming - don't worry! At some point we are probably going to have to do something about it. The question is: what?

In general, the populist clamor to "do something" about a sharp
move in commodity prices makes no sense. The price mechanism acts as a shock absorber for supply and demand hiccups, so that if storms shut down the Gulf oil platforms or rapid growth in China causes its use of automobiles to soar, oil price rises can signal to other consumers to cut back consumption and to producers to enter into new exploration projects.

That's why the fuel subsidies in Third World countries are foolish. They encourage the consumption of a substance that is increasingly scarce and at times like the present impose an appalling burden on local taxpayers or the government's financing mechanisms (as in India, where government deficits threaten to derail that country's magnificent economic boom.)

While oil prices were rising from $20 to $80 per barrel in 2002-07, this rationale seemed unquestionable. The rise was gradual, and the price remained well within the parameters that the world economy had survived, albeit with some difficulty, in the early eighties. (Although the peak 1980 price of $40 per barrel was equivalent to about $105 in today's dollars, that peak was ephemeral; the major economic effect of expensive oil came from the roughly six years of oil prices hovering around $30, or $70-80 in today’s dollars, in 1980-85.)

However, the $50 rise since September has been sudden, has taken oil prices to a level never before experienced, and shows no sign of abating. Its principal short-term cause has been the excessive lowering of interest rates and relaxation of credit conditions in the United States and elsewhere, but there are a number of long-term factors which may make it difficult to reverse.
The International Energy Agency (IEA) is said to be producing a study showing that future oil supplies will be more restricted than had been thought, topping out at about 100 million barrels per day rather than the 115 million that had been thought necessary to accommodate the world's growth to 2030. The IEA's new caution is probably inevitable, given the rise in prices and the considerable uncertainty in reserve and production estimates; it's mostly a matter of IEA geologists seeing the inexorable rise in prices and deciding to use more pessimistic assumptions about future trends.

In any case, since current production is only around 85 million barrels per day, the decline in estimated future production is not an immediate problem. However, its psychological effect on the market is considerable.

Whatever the views of the IEA, it should be clear that the recent rise in oil prices is not driven by fundamentals. Economists differ about the price elasticity of oil, but the lowest plausible estimates for short-term price elasticity are around 10%, with medium-term elasticity being much higher. Thus if oil legend T Boone Pickens is right that oil supplies are currently 85 million barrels per day and oil demand is 87 million, that is a supply shortfall of 2.4%, which at a 10% elasticity should produce a price increase of 24%, not 60%.

The principal influence behind the huge rise in oil prices has been speculation, whether by the international oil companies, by hedge funds deprived of easy pickings in the housing and equities markets, or by the oil suppliers themselves, drunk with the glory of their new-found wealth. Naturally, easy money provided by Federal Reserve chairman Ben Bernanke, European counterpart Jacques Trichet and the rest of the gang since September has empowered the speculators. Indeed, while real interest rates remain below zero oil speculators would appear to be on to a one-way bet, provided they are rich enough to sustain their buying - and the combined resources of the world's hedge funds, oil companies and dubious energy-rich Third World dictators are very great indeed.

Hence if we do nothing, but continue to focus on housing, consumer inflation and the NBA playoffs, oil prices will continue rising. This will have only a modest short-term effect, but a highly damaging effect in the medium term, as the recession-producing tendency of high oil prices works its malign magic on the long-suffering world economy.

Further rises are additionally dangerous because they may not quickly be reversed. In a market of entirely rational trading robots, the 1980 oil price spike to $40 might have been just a spike, with prices reverting within weeks to the $15 or so that was then the equilibrium. In the world of fallible speculators and other humans, the psychology of a rise to $40 made the price "sticky" on the downside at around $30, so that it was November 1985 before prices collapsed to $10. Thus if the oil price soars to $200 next week, we are probably condemned to $150 oil until 2013 or so, after which the price will collapse to $25 for several decades, as new supplies and bizarre and expensive government-mandated conservation schemes overwhelm the market.

To avoid this dreadful fate, what should we do? There are a number of possibilities:

We could invade somewhere. Considered as an oil acquisition exercise, Operation Iraqi Freedom has been a smashing success, and only appalling Wilsonian wimpiness in the US government has prevented the United States from taking full advantage of it. Iraq's known oil reserves have been increased by about 100 billion barrels since the invasion, as competent US oil companies have been free to explore for new oil employing techniques more advanced than the 40-year-old dowsing sticks used by Saddam's oil operation. At today's oil price of $130, less a generous $20 for drilling and extraction, those additional reserves have a value of $11 trillion, or approximately 10 times the most alarmist estimate of the cost of the war to date.

The problem is that the US did not secure itself a proper royalty on the new oil finds (even 10% would have been worthwhile - $1.1 trillion over the next few decades.) Nor did it ensure, by setting up a privatized oil company and a trust fund for the Iraqi people diverting oil revenues from the Iraqi government, that the new oil finds would be exploited in an efficient manner and the supplies directed properly into the world oil market. Any future invasion of an oil-producing country should avoid these two mistakes and thus make itself self-financing.

The obvious place to invade is Venezuela (even if current estimates of Venezuelan and Saudi reserves are wrong and there is in reality more oil in Saudi Arabia that could be unlocked if ExxonMobil and the boys were given free rein, the Saudis are nominally our allies, so an invasion would be considered unsporting by world opinion.) Since the 1.8 trillion barrels of Venezuelan oil deposits consist largely of the Orinoco tar sands, a Venezuelan oil-related invasion would impose an additional requirement: to keep the environmentalists away in order that reserves could be exploited with maximum efficiency.

For those who feel that invasion-for-oil is altogether too Bismarckian in its implications, there are other alternatives. The most effective would be to use the interest-rate weapon, reversing the damage caused by the cuts since September and ideally going a little further, to fight the resulting consumer price inflation. A series of small interest rate rises would not be effective, because it would enable speculators to adjust. (The 0.25% rate rises in 2004-06, all 17 of them, we now know were completely ineffective in quelling housing speculation as they allowed the speculating frog to bask in the gradually warming interest rate water, rather than being forced by a sudden temperature rise to jump out of the saucepan.)

The most effective interest rate trajectory would probably be an immediate reversal of the post-September cuts, jumping the Federal Funds rate from 2% back to 5.25%. This would still be too low to be effective in fighting consumer price inflation, currently around 4% even on the suspect government figures. However it should shock commodity speculators sufficiently to cause a sharp drop in oil and commodity prices which might, if we were lucky, become self-reinforcing enough to push oil prices down to the $80 level, which is probably the lowest we can currently expect. Once the immediate effect of higher interest rates had worn off, further rate rises, probably to around an 8% Federal Funds rate, would be needed to wring out inflation, but those could be undertaken over the next 18-24 months in the normal manner.

# It is quite certain that the interest rate weapon, if used with sufficient vigor, would quell oil prices, but it's not entirely clear whether a single rise to 5.25% would do it. However, draconian rate rises beyond 5.25% to quell oil price rises would be deeply unpopular and would cause further catastrophe in the US housing market. Since invasion is presumably off the table, the political classes may thus attempt to impose other remedies for high oil prices, all of which would be either counterproductive, disastrous or both. These might include some or all of the following: Price controls on oil companies. These would have the cathartic effect of eliminating the profits of Western oil companies, but would have little effect on the market, since the majority of oil supplies are today not controlled by Western oil companies.
# Subsidies. The effect on consumers of spiraling oil prices could be reduced by cutting petroleum taxes (as recently proposed by Senators John McCain and Hillary Clinton) or subsidizing gasoline prices directly. Such subsidies would increase rather than reduce consumption and would divert income from taxpayers (the ultimate providers of the subsidies) to the Organization of Petroleum Exporting Countries and other oil producers. Terrible and counterproductive idea.
# Rationing. Britain did this at the time of the Suez crisis in 1956, when overall rationing was still a recent memory. Its initial psychological effect would be considerable and it might well prove politically appealing to a populist, economically illiterate president after January 2009. The principal gainers from such a measure would be the Mafia, who would find a new business in stolen and forged ration coupons.
# Intensified corporate average fuel economy (CAFE) standards, ethanol mandates and public transportation subsidies. These would be highly politically attractive to the left, and are thus probably quite likely. Their effect would be far too long term to change short-term price movements. Apart from increasing costs in the economy, they would result in tens of thousands of additional fatalities a year, as the feeble mini-cars took to America's roads.
# Intensified drilling in Alaska and offshore US areas. The right-wing alternative to CAFE standards; equally ineffective in the short term but much more helpful long term. Would probably intensify the 2013 price collapse as the new sources came on stream.
# Closing down the commodities exchanges. The speculators have already found the counter to this one; a new crude oil contract is opening for trading in Dubai. To close that down, we would need to revert to the invasion option.

In summary, a sharp rise in US and world interest rates is the best way to solve the problem of spiraling energy and commodity prices, which will probably not solve itself. If that doesn't work or is "politically impossible" it's time to prepare the 82nd Airborne for jungle warfare in the Orinoco Basin.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at www.greatconservatives.com.

(Republished with permission from PrudentBear.com. Copyright 2005-07 David W Tice & Associates.)
http://www.atimes.com/atimes/Global_Economy/JE28Dj02.html