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Beware of Slogans

Slogans are comforting and easy to learn. Since late 2008 the hard-worked slogan is that cheaper oil, today, is one of the few rays of sunshine for the recession-wracked global economy. Today's variant of the mother slogan "High oil prices hurt economic growth" has little or no proof to offer, for example cheaper oil helping recovery of 4WD car sales, airline passenger numbers, house building activity, world steel output, or production of plastics, pesticides and fertilizer. The fallback slogan for cheap oil aficionados is that even if it doesn't restore growth, cheaper oil will hold down inflation.

Oil prices themselves are far above the 'nice price' of the late 1990s and first few years of the 21stC, that is below 30 USD/bbl, and at present are tending to be "surprisingly firm" at around 50 USD/bbl. This is attributed to surprisingly firm discipline among OPEC suppliers facing their own problems of economic recession and falling investment, not only in the oil and gas sector. When as likely by June-July prices bounce back above the 'psychological ceiling' of 60 dollars, despite the recession, the mother slogan that high oil prices destroy economic growth can be dusted off and recycled, as an explanation why the recession just keeps on keeping on.

Recession management and communication is a new growth industry for G-20 leaders and their spin doctors, but at present their only practical and real action to restore growth is to borrow and print money. The London G-20 summit's communiqués had references to deficit spending "up to 5000 Billion US dollars" possibly being needed to fight recession. Each day that recession continues and growth does not return is a day during which inflation will inch back. Too much money chasing too few goods is an old definition, and an older slogan than "High oil prices hurt growth". To be sure, the type of inflation which will first return is financial, simply because G-20 leaders have most and first thrown money at banking and finance establishments, corporations and entities. Returning confidence, or at least more cash and credit in the finance and bank sector will quickly translate to more Equities and Commodities futures buying – generating a few false signs of returning growth.

When this helps lever oil prices past the 'psychological ceilings' of 60-dollars or 75-dollars a barrel, higher priced oil can then fill its designer role as the complete explanation why the recession goes on but inflation is starting to return.

A quick look at world oil prices and world economic growth through the 3 years 2005-2007 shows exactly what price levels for oil are needed, if we also need 4.5% or 5%-a-year global economic growth. These prices are well above 75 USD/bbl and as we found in 2007, the global economy can easily tolerate 100-dollar oil, but not much above that, when and if global economic growth is strong.

Logically, low or suboptimal economic growth would tend to lower energy demand growth rates, which in a context of abundant supplies and no depletion would tend to lower oil and gas prices. This has many ‘perverse' or apparent illogical implications – notably (1) low economic growth favours low oil and gas prices, and (2) economic recession, or even a collapse of economic growth, is the only way to bring oil and gas prices down to ‘reasonable levels' once they start getting out of hand.

Now we bring in inflation. 2005-2007 clearly showed that inflation stays low, even with oil prices edging towards 100 USD/bbl, if and when world economic growth stays high or very high. This for example means 10%-a-year GNP growth for China. When or if oil prices stay high, but economic growth falls, inflation is not just possible but guaranteed .

The global economy mechanism which kept oil demand growth low, and oil prices low through the late 1980s and 1990s is complex and ramifying. We can however explain it through the single indicator of world average per capita oil demand, or oil intensity, in barrels-per-capita consumption each year.

In 1978, with oil prices expressed in 2009 dollars in the region of USD 60-per-barrel, but with global economic growth only about 3% annual, world oil intensity reached its ultimate all-time high. In 1978-79 world oil intensity was 5.5 barrels/year. After that we had the "Iran shock" or Khomeini revolution, that is geopolitical shock and a sharp fall in Iranian oil exports. This produced the second Oil Shock of prices way above 100-dollars in today's money, as global economic growth plunged and inflation started growing – and growing. The net impact for oil was simple: Oil intensity fell consistently if erratically to about 1985, then stayed low right through the 1990s.

Today's oil intensity using IEA figures for world oil demand in March 09 at around 84 Mbd or 30.66 Billion barrels/year and world population at 6.7 Billion is around 4.6 barrels/capita. This is about 17% less than 1978. Put another way, if today's world consumed oil at the intensity of 1978, world oil demand would be around 20% (not 17%) more than today – or just above 100 Mbd.

To be sure, population enters into the equation. In 1978 world population totalled about 4.2 Billion or 2.5 Billion less than today: in other words today's population, all of them consumers of oil or potential consumers, has grown by the equivalent of about 8 new USA's or 16 new Japan's or 40 new France's since 1978. Luckily for world oil reserves, the 2.5 Bn increment since 1978 has been over 90% concentrated in poor or very poor, low oil intensity countries. If for example the world economy added another 8 USA's and consumed at US intensity, world oil demand would grow by about 160 Mbd.

What counts for us today in the present structure of the global economy, at present population size, is that even 1978-level oil intensity is completely impossible. World oil output at 90 Mbd is unlikely. Raising it to 100 Mbd and sustaining this, as even the IEA is beginning to admit, and is openly admitted by oil chiefs like Total's CEO, is a certain loser bet. We can repeat that even raising world total 'all liquids' output to 90 Mbd and holding that for more than a couple of years may not be possible. Average per capita oil demand is therefore falling and will go on falling .

We can note the downturn in oil intensity, from about 5.5 barrels/capita (bcy) in 1978 to around 4.4 bcy in 1985 was rapid – and nursemaided by extreme high inflation-plus-sharp recession. Today we have an oil intensity (4.6 bcy) a little higher than this most recent extreme low, and the same intense economic recession, but not yet the inflation. Repeating 1978's ultimate peak oil intensity of global per capita demand is impossible, but repeating the inflation-and-recession shock of 1980-1983 is unfortunately both possible and easy.

World oil intensity increased fast but erratically through the 1970s, from about 4.25 bcy (barrels per capita/year) in 1970 to attain the ultimate peak of a little more than 5.5 bcy in 1978-79. Since that time, any time there has been more than a few years of strong economic growth worldwide, oil intensity has grown. Through 2000-2007, for example, intensity grew from about 4.5 bcy to 4.8 bcy. In other words and unsurprisingly, rising per capita income and faster economic growth needs and means burning more oil per capita.

We can be sure there are other factors in play, deciding when or if oil prices rise, and oil's relations with economic growth and inflation. Technical and policy factors include natural gas and coal supply and prices, energy import dependence and security considerations, climate change mitigation through carbon taxation and development of alternate energy, and so on. What is sure however is that current global economic recession, falling oil demand, and low inflation are unrelated to or decoupled with near term and accelerating oil depletion trends. We can show this with a few simple figures: world oil intensity by 2020 using increasingly converging IEA and ASPO estimates and forecasts for depletion trends, cutting oil output and net supply by as much as 20 – 25 Mbd, could be as low as 3 bcy.

This is the 'long-term' outlook, for the far future of a little more than 10 years ahead. The near-term of the next 10 months, to early 2010, also threatens large and unexpected oil price rises, driven not only by depletion but also by a mix of little-appreciated but converging trends. These include geopolitical shock in the Mid East, the depth of the current recession, and the massive spending of borrowed and printed cash that G-20 leaders have decided as their way to fight recession. Put another way, the ‘oil shock' of 1979-81 (an approximate doubling of average price-per-barrel) was not only driven by geopolitical shock and supply shortage, but also by very high and growing inflation. This can be the near-term outlook again, today.

What counts is that for at least 35 years, since the first oil shock of 1973-74, which saw a very fast rise of about 295% in average price-per-barrel, there was almost no effective reduction in oil intensity each time that prices increased from a derisory low level, to price levels easily absorbed and handled by the global economy. In the current context of prices around 50 USD/bbl (early April 09) a doubling to 100 USD/bbl would almost surely be too extreme for the global economy, but 75 USD/bbl would be easily absorbed – and would boost the economy.

The real impact of higher oil prices, certainly to price levels well above 60 USD/bbl is to increase economic growth at the global, or aggregate worldwide level. In the very short-term, say 1 – 3 years ahead, quickly levering up global economic growth could or might not only raise or maintain public approval of political leaderships and prevent slump into 1930s style depression – but also mitigate the inflation shock that is coming, either before oil prices rise, or after oil prices rise. In the longer term of 3 – 5 years ahead, reduction of world average per capita oil demand, that is intensity reduction, will be one of the most critical and basic targets for all leaderships in the G-20 group.

Totally unlike the 1970s and 1980s, we have an outlook of around 3.5 Mbd-per-year depletion loss of conventional lower-cost oil production capacity. Through 2009-2015 this rate could, under pessimistic but rational scenarios become the net loss rate of world export supply capacity. Only extreme high spending and investment in the oil and gas sector will mitigate and reduce this loss rate, but almost any scenario says there will be an overall and big cut in supply in the coming 5 or 6 years.

This would set a ceiling of well below 90 Mbd total production and 50 to 55 Mbd export and traded oil supply. One likely scenario is around 87.5 Mbd maximum production capacity, and about 51 Mbd export supply capacity for 2009-2010.

We can therefore set Zero Growth for world oil imports as a very near-term constraint, quickly followed by as much as 6%-a-year cuts in average export supply. Sharing this pain between the world's 120-plus oil importer countries will be challenging.

In the short-term (that is 1 – 3 years ahead or 2010-2012) the inflation outlook is not so much possible but sure and certain. This is made even surer and more intense by incredible amounts of deficit spending decided by G-20 leaderships. Without a rise in global economic growth far above current IMF or IBRD forecasts (which are as low as 2%-a-year), inflation is at least equal to oil as the global economic bogeyman.

Any check on the two 1970s vintage oil shocks will show they both featured geopolitical shocks in the Mid East, oil production cuts, and export supply shortfall – or worse, that is political export embargo. Absent from the scene was oil reserve depletion, chipping away at total production and world oil export capacities, due to the 1970s decade following right after two decades of huge discoveries. On the demand side we had a much less-than-globalized world economy.

Other differences explain why inflation, today, can grow at least as fast but perhaps not as high as in 1979-81. This specially includes world food supplies and production infrastructures, soil and bio resources, water, transport or the 'supply chain'. A handy way to think of food production and supply is Food = Water + Energy. In 2007-2008 the impact of oil prices well above 100 USD/bbl helped detonate an already latent world food supply crisis. One year's good harvests (2008) and cheaper oil in no way mean that high food prices have disappeared forever. Rising food prices are a much more 'traditional' cause of inflation and recession than higher oil and energy prices, we can note.

Not only higher inflation, but also any decline in the world value of the US dollar are sure drivers of the world oil price, most major traded agro-commodity prices, and therefore food prices. In the current context of G-20 leaders readily accepting talk of "5000 Billion US dollars" of what are called 'injections' in the world's finance, banking and other economic sectors such as bankrupt carmakers and airlines, fast-growing inflation, starting with food prices is a highly rational forecast.

On the oil side either geopolitical shock, or seismic, weather, industrial accident or other damage to oil production and transport infrastructures can generate the context in which oil prices grow faster and before world food prices. Here again, we face underappreciated or ignored real world pressures. Today's Mid East and central Asian geopolitical context is more dangerous, more widely stressed than for many years. Although not concentrated and focused in and on Iran at the fever pitch preceding the Khomenei revolution, the region-wide context of smoldering conflict now extends far and wide, as the Afghanistan war spills over to Pakistan. Today's potential conflict zone covers countries and territories as widely spread as Armenia, Chechnya, Turkey, Somalia and Sudan.

We can surely not give an exact date and time of day for the start of geopolitical conflict generating a fast growth of oil prices, but for inflation growth, world oil export supply shortage and the inevitable oil price recovery this generates, we can identify the very short-term as beginning to record impacts of change. This will be within the next 3 months or by June-July 09. For world food and agro-commodity price growth we have similar timelines, that is net and perhaps large growth in average prices by late Summer 09.

Cheap Oil neither guarantees fast economic growth nor lowers inflation – which is likely to grow very fast due to massive deficit spending and higher food prices.

Oil reserve depletion and decline of export supply to zero growth in the very short term (before end 2010) will drive higher oil prices unless there is 'permanent economic recession'.

Even with longer-term slow growth or zero growth of world oil import demand, prices will rise. This process will start in the short-term and will continue for decades ahead.

Cheap oil and energy remains essential to conventional economic development, indicating that very determined and well-funded programs for Energy Transition are needed, over and beyond effort for Energy Transition to mitigate climate change.

Conventional or classic economic growth will be levered up by higher oil prices, certainly to prices around 75 USD/bbl. In the current context, due to inflation menace, restoring global economic growth is vital. Because of this, higher oil prices should be welcomed not feared

Geopolitical shock, natural disasters or any other cause of oil supply shut-down will very quickly lead to higher prices despite the economic recession. This is due to depletion effects, which will grow

Andrew McKillop is an energy economist and consultant. He has held posts in national, international and supranational (Euro Commission) energy, and energy policy divisions and agencies. He is the editor of 'The Final Energy Crisis', Pluto Books; and co author with Salah al-Shaikhly of 'Oil Crisis and Economic Adjustment', Pinter Publishing. He is a frequent contributor to Petroleumworld and several other energy related sites and groups. Petroleumworld does not necessarily share these views.

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Petroleumworld News 05/02/ 09

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