The Next Oil Shock

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There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is a part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
—John Kenneth Galbraith

Those who cannot learn from history are doomed to repeat it
—George Santayana

When will the next oil shock occur? This is a question of interest to many, but it’s not much in the news lately. People tend to forget last year’s crisis. They’re now preoccupied with a barely functioning economy which was further hobbled by the oil price spike in 2007 and the first half of 2008.

Today I attempt to set reasonable expectations about the timing of the next oil price spike. For simplicity’s sake, I will define an oil shock to be a 2 month period where oil prices exceed $110/barrel. My working assumption is that such a shock, after some time lag, will once again help bring a structurally unsound world economy to its knees.

The world is awash in spare oil production capacity. This is not surprising, given—

1. An estimated drop in daily consumption of 2.5 million barrels in 2009, following a drop of 0.3 million barrels-per-day in 2008 (see Figure 1 below).
2. Saudi Arabia has finally reached a stated capacity of 12 million barrels-per-day (b/d) with the recent additions of Khurais and Nuayyim, and the expansion at Shaybah. Their July production was only 8.04 million b/d. The Saudis are reworking Ghawar to take advantage of the opportunity offered by low global demand.

Determining when the next oil shock will occur is deceptively simple: it will happen when world demand rebounds to 2007 levels. On the supply side, there’s no reason to believe the Saudis will ever produce more than 10.5 million barrels-per-day, and even this ceiling is probably too high. If you add in the other OPEC unused capacity, and subtract non-OPEC production lost from field declines or lack of investment, it’s basically a wash. Demand at 2007 levels will once again test the oil supply. But when will demand pick up another 2.8 million barrels-per-day?

[Update: The IEA’s August Oil Market Report “estimates that global oil demand will contract in 2009 by 2.3 million b/d vs. 2008 and average 83.9 million b/d.” This is an upward revision in 2009 demand of 200,000 barrels-per-day. So the question becomes when will demand pick up another 2.6 million barrels-per-day?]

The International Energy Agency (IEA) believes we could add another 1.4 million b/d of new demand in 2010 (Figure 1).

Figure 1 — Taken from the IEA’s July, 2009 Oil Market Report. Historical demand growth data are shown on the left, and I have circled the years 2008-2010. The IEA draws a strange curve fit (gray line) that shows that if global real GDP grows 4% year-over-year, oil consumption will grow by nearly 2%. (On the other hand, oil demand hardly rises at all if global GDP grows by 2%, and growth below 2% implies negative oil demand growth!) You can see the IEA’s demand growth estimate in barrels-per-day on the right.

The IEA explains its bullish forecast—

In 2010, by contrast, the picture could be dramatically different. As a starting point, this report uses IMF economic assumptions (World Economic Outlook, April 2009), which posit that global economic growth will reach +1.8% in 2010, compared with ‐1.4% in 2009 – that is, a swing of over three percentage points. Under this scenario, oil demand is expected to rebound by +1.7% or +1.4 mb/d year‐on‐year to 85.2 mb/d – but still way below 2008 levels. Unsurprisingly, this strong rebound is poised to be led by non‐OECD countries, where demand should expand by +3.5% or +1.3 mb/d, close to levels seen in previous years and following zero growth in 2009. China, the Middle East and to a lesser extent Latin America will play a prominent role. The OECD, meanwhile, should also post a modest recovery (+0.2% or +100 kb/d) as most of its economies gradually emerge from their deepest slump in over half a century, with North America being arguably the engine of growth.

Almost all the new demand comes from emerging markets (China, the Middle East and South America). The IEA bases its conclusion on the International Monetary Fund’s April, 2009 World Economic Outlook, but the IMF has already upped its forecast since the IEA published its July report.

The world economy is stabilizing, helped by unprecedented macroeconomic and financial policy support…

Accordingly, global activity is forecast to contract by 1.4 percent in 2009 and to expand by 2.5 percent in 2010, which is 0.6 percentage point higher than envisaged in the April 2009 WEO (Table 1). The higher annual average growth rate for 2010 largely reflects carryover from a markup in growth during the final half of 2009. On a fourth-quarter-over-fourth-quarter basis, real GDP growth is projected at 2.9 percent in 2010, compared with 2.6 percent in the April WEO forecast.

[My note: there is discrepancy of 0.1% between the IMF’s April number and that cited by the IMF. I will ignore it.]

Whereas the IEA thought oil demand would grow by 1.4 million b/d, it would now appear that the more bullish IMF revision, which forecasts a year-over-year swing of ~4% GDP growth in 2010, implies (via Figure 1) that oil consumption will grow by nearly 2% in 2010 (~1.6 million barrels-per-day).

If the IMF’s forecast is correct, we might expect the next oil shock as soon as 2011 as demand revisits 2007 levels. So now the question becomes: will the global economy rebound as sharply as the IMF believes?

Beware Official Forecasts!

The next three graphs illustrate why it is always necessary to question official growth forecasts. Debunking bureaucratic estimates is like shooting fish in a barrel.

Figure 2 — The graph is taken from Six Impossible Things Before Breakfast, a critique of the Efficient Markets Hypothesis by James Montier of Societe Generale in London. Official U.S. forecasts (gray line) always expect GDP growth of between 2 and 3.5% with only minor variations. In the real world (red line), growth is erratic and recessions (or downturns) occur. Note the “V-shaped” recoveries from prior recessions. Overly optimistic analysts (salesmen) believe this pattern will reappear after the current Great Recession ends.

Figure 3 — The prospects for world GDP growth (year-on-year percent change, top frame) from the IMF’s April, 2007 World Economic Outlook. The IMF estimated the percent change in growth in 2008 would be at worst +3.3% with 90% confidence. The IMF assessed the global risk factors affecting their forecast (bottom frame). Note that the assessed risk from the U.S. housing sector and the oil supply was lower in 2007 than it was in 2006.

Figure 4 — The actual percent change outcome for world GDP growth from the IMF’s April, 2009 World Economic Outlook. Contrast the outcome with Figure 3 (top panel) above. In 2009 the worst case (in the 90% confidence interval) is a -1.4% percent change in 2010. In other words, the baseline forecast reflects official optimism, but the world economy could shrink again in 2010 in the worst case.

We should not have much faith in the IMF’s baseline forecast for world GDP growth of 2.5% in 2010. The IEA’s oil demand growth scenario depends on the IMF estimate, so we should not necessarily believe that story either.

Chimerica

I’m no better than the IMF at predicting what the percent change for global GDP will be in 2010, not to mention the greater uncertainties associated with the years beyond that. All I can do is discuss a few factors that cast doubt on predictably rosy official estimates.

By far the largest economy in the world is the one which has no name. Niall Ferguson calls it Chimerica.

We are living through a challenge to a phenomenon Moritz Schularick and I have christened “Chimerica.” In this view, the most important thing to understand about the world economy over the past decade has been the relationship between China and America. If you think of it as one economy called Chimerica, that relationship accounts for around 13 percent of the world’s land surface, a quarter of its population, about a third of its gross domestic product, and somewhere over half of the global economic growth of the past six years.

[My note: Read my A Resurgence In China? for some necessary background on the symbiotic relationship between the U.S. and China, and the prospects for future GDP growth in China.]

Chimerica is responsible for over half of world GDP growth in the past 6 years. As this theoretical entity goes, so goes the world.

I presented my forecast for GDP growth in the United States in Don’t Buy Stuff You Can Not Afford. Our prospects for a robust economic expansion in the next few years—a “V-shaped” recovery—appear to be dismal. I would only add that the unreformed financial sector creates substantial downside risks. Despite a temporary lull in our level of alarm, too-big-to-fail banks Citigroup and Bank of America, among others, are still insolvent.

The threat of new bubbles—grossly inflated asset values like those we’re starting to see in the S&P 500—persists, and the continued existence of an unrepentant, unfettered, politically powerful and voracious giant vampire squid on Wall Street (aka. Goldman Sachs) heightens the dangers. Former chief IMF economist Simon Johnson of Baseline Scenario had this to say about Wall Street’s role in America’s economic future.

If the bubble (or metaboom with a series of bubbles) was in finance and pulled resources into that sector, we face an adjustment away from Peak Finance – and perhaps this will even more overshadow the next decade than peak oil.

The economic adjustment will not be easy for the [United States, which] will likely struggle with the political adjustment – the financiers will not easily give up their license to extract resources from citizens, either directly or through newly found rents channeled through the state (and coming ultimately out of your pocket, of course).

The political consequences of Peak Finance greatly complicate our economic recovery.

[My note: That’s what giant vampire squids do, they extract resources (rents), even as they spurn making $36,000 loans to small businesses.]

While the United States flounders, China is said to be booming. On the face of it, China’s economy is flourishing amidst the global carnage.

China bought record volumes of oil and iron ore in July as automakers, steel producers and builders expanded output to meet rising demand driven by the nation’s $586 billion stimulus spending. Oil imports jumped 18 percent to 19.6 million metric tons [4.52 million b/d], and iron ore purchases rose 5 percent to 58.1 million tons from a month ago…

Crude steel production in China, the world’s biggest maker, surged 13 percent last month to 50.7 million tons, the National Bureau of Statistics also said today in Beijing. That’s the third consecutive record monthly high… Iron ore is used in steelmaking. “Iron ore restocking pushed up the imports and prices as the stimulus package drives up steel demand…”

[My note: But China’s “crude output [production] fell 0.3 percent to 16.14 million tons [3.8 million b/d] last month.” This yields a record-setting consumption total of 8.32 million barrels-per-day. But the important question is whether Chinese oil production is now in permanent decline following its peak/plateau phase? Why would their production be going down when the economy is booming? This subject has to be examined at length some other time.]

Based on commodity imports alone, we might conclude that China will lead the world out of the economic doldrums in 2010. But all is not as it appears on the surface (Bloomberg, August 11, 2009).

China’s exports and new loans tumbled in July and industrial output rose less than estimates, underscoring government concern that the world’s third-biggest economy is yet to establish a solid recovery. Exports fell 23 percent from a year earlier, the customs bureau said. Industrial production gained 10.8 percent, the statistics bureau reported. New loans plunged to 355.9 billion yuan ($52 billion), less than a quarter of June’s level, the central bank said…

Urban fixed-asset investment for the seven months to July 31 climbed 32.9 percent, the statistics bureau said. That was less than a 33.6 percent gain through June and the 34 percent median estimate in a survey of 22 economists. “The fixed-asset investment number is worrying because government-sponsored investment is a pillar of the recovery,” said Toa Dong, chief Asia-Pacific economist at Credit Suisse AG in Hong Kong. “This set of data should postpone any thought of more aggressive tightening; the economy is slowing down a little bit.”

[My note: In an attempt to inflate stock and commodity prices, the giant vampire squid is bullish. “China’s economy will grow 9.4 percent this year, topping the government’s 8 percent target, Goldman Sachs Group said yesterday.”]

There are disturbing signs that China’s economy is overheating, which typically leads to massive misallocation of resources as asset values over-inflate. The Shanghai Composite Index is very bubbly, and so are house prices in China’s cities, as reported by the Wall Street Journal in China’s Market Bubble Not Close To Bursting—Yet.

For months, Chinese markets have been in the grip of a growing speculative frenzy. The run may have further to go, because bubbles frequently last longer than observers expect they will. The situation should raise concerns for investors in all emerging markets, especially in Asia. If the mania leads to a crash, the damage will not be contained.

Signs of an emerging Chinese bubble are all around. The Shanghai and Shenzhen stock markets have doubled from their lows last fall. Retail investors, who show up at every bubble, are back in action: Trading volumes last week on those markets surpassed the peaks seen in late 2007. And shares are expensive: According to Credit Suisse, the domestic A shares in Shanghai now trade for about 23 times forecast earnings, and nearly four times book value…

Chinese real estate, already at lofty levels, has risen alarmingly fast lately. According to Frank Chen, a Hong Kong-based analyst with brokerage Yuanta Securities, average home prices in some cities on the mainland, such as Shanghai and Shenzhen, may have risen by more than a quarter since the start of the year. That may leave average prices in relation to household incomes higher than they are in New York, London, San Francisco and Sydney.

With economies in the rest of the world flagging, what’s driving the China boom? The Chinese economy continues to grow—it expanded by 7.9% in the second quarter—the real juice, as usual, has come from easy money.

Bank lending is at high levels. The Chinese government has embarked on a $586 billion stimulus plan that includes giant infrastructure projects to keep the economy rolling. Interest rates are low: Since last September the typical three-month deposit rate has fallen by about half, to 1.7%. So mainland Chinese investors are looking for other ways to grow their money.

But don’t worry about the Shanghai stock market bubble or inflated house prices says Vitaliy Katsenelson in China’s Bubble’s Coming—But Not The One You Think (Foreign Affairs, July 23, 2009).

Forget about a Shanghai stock bubble. The whole Chinese economy’s getting ready to burst…

Now, China needs to stimulate its economy. It’s facing a very delicate situation indeed: It needs the money internally to finance its continued growth. However, if it were to sell dollar-denominated treasuries, several bad things would happen. Its currency would skyrocket — meaning the loss of its competitive low-cost producer edge. Or, U.S. interest rates would go up dramatically—not good for its biggest customer, and therefore not good for China.

This is why China is desperately trying to figure out how to withdraw its funds from the dollar without driving it down—not an easy feat.

And the U.S. government isn’t helping: It’s printing money and issuing Treasuries at a fast clip, and needs somebody to keep buying them. If China reduces or halts its buying, the United States may be looking at high interest rates, with or without inflation. (The latter scenario is most worrying.)

All in all, this spells trouble—a big, big Chinese bubble. Identifying such bubbles is a lot easier than timing their collapse. But as we’ve recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer excesses persist, the harder the financial gravity will bring China’s economy back to Earth.

The Chinese half of Chimerica is becoming dangerously overheated, which spells trouble for the United States. Even if Katsenelson’s worst case outcome—China dumping dollars to finance their domestic growth—does not occur, there can be little doubt about the eventual outcome when China’s current stock market and real estate bubbles collapse. Since we are interested in the timing of the next oil shock, we need to look at the typical time frame in which bubbles rise and fall (Figure 5).

Figure 5 — Taken from Six Impossible Things Before Breakfast (referenced in Figure 2). James Montier says “In my own work I’ve examined the patterns that bubbles tend to follow. By looking at some of the major bubbles in history (including the South Sea Bubble, the railroad bubble of the 1840s, the Japanese bubble of the late 1980s, and the NASDAQ bubble1), I have been able to extract the following underlying pattern. Bubbles inflate over the course of around three years, with an almost parabolic explosion in prices towards the peak of the bubble. Then without exception they deflate. This bursting is generally slightly more rapidly than the inflation, taking around two years.” The Wall Street Journal notes that “though [China has bubbles], investors shouldn’t necessarily get out now. The frenzy has not yet reached the epic, wild proportions that typically mark the end of a bubble. There’s much money to be made there, and it could be awhile til the bubble pops.”

A very complex picture is now emerging. The key questions are—

• Will China’s bubbles proceed apace and pump up world oil demand over the next few years? In this case, the bubbles will eventually burst, thus causing 1) economic collapse in China, and 2) the next oil shock prior to or simultaneous with that event. Or will the Chinese leadership realize the dangers, and sensibly slow down China’s economic growth?

Because China has a command & control economy, all the important economic decisions lie in the hands of the state. If the Chinese leadership decides to go full speed ahead, we might expect the time to bubble collapse to be faster than the 3-year average shown in Figure 5.

The Next Oil Shock

I have not changed my view of future oil prices. I described that view in The Price Is Not RIght (December 17, 2008).

Figure 5 — The Boom & Bust view of future oil prices as explained in The Price Is Not Right. The figure has been annotated to show where we are and my best guess concerning the timing of next oil shock. I believe it will occur in 2012 plus or minus 1 year, given the uncertainties about Chimerica discussed above.

I have ignored many secondary variables (e.g. more oil demand in the Middle East, Europe’s shrinking economy, Japan’s severe downturn) that will have an impact on future oil demand. I did so to simplify the discussion. I believe the future of Chimerica, which is undergoing great changes now, is the most important factor affecting the timing of the next oil shock.

The global economic situation is very fluid. Uncertainty reigns. The IEA admits that the oil demand growth they estimated for 2010 could “fail to materialize.” Stay tuned.

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