Reflections on Oil

I once visited an art installation which consisted of a pool of oil maybe 10m long by 5m wide at about 1.25m high. It was indoors and still, so, at the angle you looked at it, the reflection was near-perfect. Apart from a few dust motes on the surface it was like a supernatural (using the word in the sense made popular by the late Lyall Watson) mirror onto the world.

Let’s see what light reflecting on oil can shed on the current economic turbulence.

My thoughts on the price of oil were prompted by a piece “Welcome to a world with $500 oil” by Willem Buiter at the FT (non-subscribers may not be able to view Buiter’s blog) a week ago. I was away from a computer, made some notes, lost them, and now I’ve found them again. So here goes…

If you’re not living on a desert island you will be aware that we are witnessing “demand-destruction” at current oil prices around $130 a barrel. How, you may wonder, could reputable economists predict a price of $500/barrel?

To answer this question we’ll have to explore the pathologies of the global economy. In short, when it comes to oil, the global economy is being severely distorted. The price you pay at the pump is not simply a result of supply and demand for oil around the world. Yes, we’re all connected in one global economy. But the global economy is as imperfect as the image seen in a fairground distorting mirror. The actual price of oil to consumers in (say) the developed countries is a result of political decisions, exchange rate manipulation and subsidies, in short government interference conducted on a colossal scale.

Now, in trying to prevent global warming, effective solutions will have to rely on market-forces. Perhaps, before proceeding, we need to consider how well our market is actually operating.

We live in a complex world, but let’s consider three classes of nation state:

– the “developed” (I hate this term) countries, in particular the EU and US – those who either are or can be expected (from 2012) to attempt to meet Kyoto-style consumption targets;

– the industrialising countries, such as China and India;

– the oil-producing countries, especially OPEC and Russia.

Developed Countries

With oil at $130 we are seeing demand destruction in the developed countries. Probably enough demand destruction to cause a cyclical downturn in the price of oil. As such cycles always overshoot, my bet is that we will see $50 oil again at some point in the next few years. Of course, once we have made efficiency improvements (in particular more mpg), consumption will increase again, since driving will be good value once more.

But this demand-destruction is only happening because governments are (by and large) making sure consumers pay the true supply and demand price of oil. In fact, they are even prepared to make consumers pick up the cost of some of the externalities of oil use by imposing fuel duty. Carbon-trading, where it is applied, represents an attempt to ensure consumers pay for the global warming externality.

Oil well and good.

Industrialising Countries

These countries do not, in general, pass on the full cost of oil to consumers. In India, for example, heating oil is subsidised. The price of oil doesn’t increase only far enough for consumers to change their habits. The government has to feel the pain and then impose a price rise on an unhappy population.

Not only that, but the currency of many countries is artificially pegged to the dollar.

Digression: Trade Imbalances Cause Credit Crisis AND Oil Spike

Here’s some food for thought. For years the Jeremiahs* have been warning us about trade imbalances. Now I just wonder if this isn’t an underlying cause of both the credit crisis – since the real problem was the cheap loans, partly made possible by the need to invest trade surpluses, which drove house prices up in the first place – and the oil price rise (and commodity inflation). What is happening in the world today, I suggest, is that – looking for gold at the end of the development rainbow – many people are doing work for much less than its true economic value. Many are being exploited and living in appalling conditions on low wages. But for other occupations in the same economy – say IT work in India, white-collar jobs carried out by the burgeoning Chinese middle class – consumption patterns are approaching those in developed countries. Such workers cost much less in dollar terms not because they are more efficient than the developed country competition (likely they are less efficient) but because they are in a “developing” country. In short, they benefit from the vast army of cheap labour.

Cheap Labour and the Cause of Trade Imbalances

Here’s my proposition:

1. Exploitation lowers costs indirectly for developing country exporters. It’s not that the IT worker in Bangalore is directly exploited. It’s the exploitation of the guy living on a few dollars a day who brings the lunch to the IT worker’s desk which allows the IT worker in Bangalore to undercut the IT worker in Basingstoke.

2. The inefficiency in labour terms of making the IT worker redundant in Basingstoke in order to employ two in Bangalore to do the same job allows the developing country to build up a trade surplus.

3. The problem would be much reduced if the IT worker in Bangalore had to pay the UK price for petrol. If it’s subsidised (or even if there is less duty and/or carbon tax included in the retail price) he will be able to consume more relative to the value of what he produces. The trade surplus allows more oil to be consumed than would otherwise be possible. [Actually India wisely allows the rupee to float, so doesn’t have an overall trade surplus. The argument applies insofar as India has a massive trade surplus in IT services].

How Developing Countries Will Cause the Next Oil Price Spike

I mentioned that many developing country currencies are pinned to the dollar allowing trade surpluses to be maintained, albeit at the cost of some inflation. Surely if the currencies were allowed to appreciate then developing countries could afford even more oil? Well, yes, they could as long as they were able to maintain their trade surpluses.

Here’s the problem for developed country consumers. If developing countries (China, you know who you are!) break the dollar peg (i.e. allow their currencies to appreciate) they will be able to push up the price of oil (at the expense of some loss of exports).

If they maintain their trade surplus (by keeping their currency low) they will be able to push up the price of oil, until the trade imbalances becomes unsustainable. Without currency movement this will happen in the worst case when developed countries are unable or unwilling to service their debts, but before then when they are unable to borrow or borrowing becomes too expensive. Recognise anything yet?

One problem is that the developed countries such as the UK and US seem to be happy to nationalise private debt either directly (Northern Rock, Fannie and Freddie) or indirectly by tax-giveaways and budget deficits. The wrong policy in my opinion, but let’s not digress too much.

The conclusion is that because of their trade surpluses and unwillingness to pass the true supply and demand cost of oil onto consumers, the developing countries will be able to push the price of oil up well beyond today’s levels. Many scenarios are possible, but here’s a likely one. Once demand-destruction in the US in particular pushes the cost of oil down to around $50, it will bounce because of demand from China and India, in particular, which will continue to increase even as the developed countries move away from oil. Until…

All this is a colossal mistake of course, because, in a short-termist rush to develop, economies are being created that are not only highly inefficient (in labour terms) but also reliant on limited supplies of energy. If we continue on this path, then somewhere along the line this inefficiency will be exposed, and there will be economic meltdown on the scale of the fall of the Soviet Union or the Great Depression.

Maybe the developing countries could push oil to $500/barrel, but there are other players in the market.

It gets even worse.

The Oil Producers

Now, here we have a real problem.

Oil producers get free money.

It’s only in the last half-century or so that countries have not had to work for resources. The security guarantees of the present world order, coupled with the voracious global appetite to consume, provide unparalleled riches without the burden of corresponding military expense.

Oil producers get free money.

They give oil (and money) away to keep their population happy. This raises the price of oil by reducing the amount available for export, that is, the supply to consumers in importing countries.

They have built up huge sovereign wealth funds (SWFs). They practically have more money than they know what to do with. More to the point, the larger the SWF, the more the oil-producing country can afford to consume each year. The process is cumulative.

Venezuela is giving away oil for political influence.

The Gulf states are building colossal cities. Building these consumes oil. The cities are unlikely to promote efficient use of oil, because it’s cheap in these countries. And worst, these projects, even if they could not be justified without the surplus capital from oil revenues, create industries and put money in the hands of their populations, leading to still more oil consumption.

Now, the oil producers only judge they need so much money from exports.

Here’s the screamer: the higher the oil price, the lower proportion of their oil the oil-producing countries will tend to export.

I see I should have written this blog post a week ago, since a comment on Willem Buiter’s blog makes a similar point, referring to a blog from India (hi over there!).

So over a period of decades there is a massive positive feedback in the system.

I suggest we’re witnessing only the First Oil Demand Shock, as consumers in “developed” economies are forced to cut back on their use. I suggest the most destructive in human terms will be the Second Oil Demand Shock when those countries who are currently building economies reliant on affordable oil are forced to cut back their consumption. If I had to guess I’d expect this Shock in about 2020. The Third Oil Demand Shock will be a long drawn-out affair when one by one the oil-producers are unable to maintain the profligate lifestyles of their populations and are afflicted by the Curse of Oil.

Unless of course we think in the meantime of some way of keeping the stuff in the ground.

* I wonder whether the language police have ruled this usage (”doleful prophet or denouncer of the present age”, Concise Oxford Dictionary 7th edition, 1982) ideologically unsound for some reason, since it doesn’t appear in Wikipedia, the Wiktionary or dictionary.com. Sorry if anyone’s offended.