The Next Catastrophic Crunch Will Be Oil: Set to hit the USA just like In 2008

Wednesday, Aug 31 2011 by
17
The Next Catastrophic Crunch Will Be Oil Set to hit the USA just like In 2008

Everyone was waiting with baited breath for the news about QE-3. But perhaps the number to watch was Q-3 nominal GDP, coming soon!! The important message Ben Bernanke had in Jackson Hole was that the Federal Reserve cannot, on its own, create economic growth in America (or jobs), simply by making it more or less attractive for banks to lend; and thus for Americans and foreigners to borrow. Or by printing money to buy over-priced toxic assets so the ATMs still work, or to help the Treasury improve the structure of their debt, by buying long bonds real cheap from Bill Gross…Hey Bill, that was a patriotic thing to do!

But Mr. Helicopter wasn’t very specific about whose job that was, although one would have thought that in a free-market democracy that would be the job of either the “free-market”, or the elected representatives, or a combination of both? Either way, both of those have been conspicuously MIA (Missing-in-Action) for quite some time, like since the time Gerald Ford was in charge; Alan Greenspan correctly characterized him as the only “decent and sane” American President he had any dealings with; “the man who vetoed everything stupid that Congress put out” (I paraphrase).   

Meanwhile America mutates into a quasi-fascist state where the population must serve at the pleasures of a small minority of super-rich. Who enjoy the luxuries of the protection of their wealth that is provided by the Law (particularly the one about three-strikes-and you are out), plus the huge investment in military power. Make no mistake; America spends half of what the whole world spends on defense to keep the wealth of 1% of the population “safe”, not to keep ordinary Americans, the ones who serve the rich…”safe” (guess who’s side I’m on).

Meanwhile in Belgium there was a conference to discuss whether or not the gyrations in the price of oil over the past few years were due to (a) speculation or (b) something else. 

There are three schools of thought:

1: There is a (fairly recent) idea that when the amount of money the world pays for oil (in nominal dollars) gets above 3.3% of world GDP (also in nominal dollars), the extra input cost slows world GDP, but when it is less than that, it has no effect; i.e. high oil prices slow GDP growth but low prices don’t particularly speed it up. I was intrigued by the number 3.3% because that is exactly the same number that I came up with by two (other) separate approaches to try and figure out what is the fundamental price of oil, i.e. the price of “equilibrium” on the demand side of the equation. Like an Err…SNAP moment!! Although me I call that process “Parasite Economics” and the fundamental “market equilibrium” I’m interested in is just how much milk you can suck out of Daisy before she keels over with a nasty dose of mastitis.

That red line, which I call the valuation estimate of the “fundamental”, is defined by the equation which one day I suspect may eventually replace E=MC2 and the General Theory of Economics (as proposed by Keynes), and can be expressed:

FOOT = 3.3 x TOAD/OIK

Where:

FOOT = Fundamental Of the price of Oil Today

TOAD = TOtal Of All De (the) nominal GDP in the world

OIK     = Total of all the OIl Konsumed.

2: Another school of thought has it that there are now constraints in production of oil, and prospects of further constraints as oil is currently getting discovered and developed, slower than the rate at which it is being used. Another way of saying that is that the replacement cost, i.e. the cost of finding new oil and bringing it to market, is what determines the correct (i.e. fundamental) price. I would like to emphasize that “replacement cost” is not the cost of pumping oil that has already been found out the ground, it is the cost of finding an equal quantity of oil that hasn’t been found yet, and pumping that to the market.

And thus the gyrations of the market reflect a flip-flop between pricing the current value of replacement cost, which is hard to know…the head of Exxon says it is $75, the BP disaster suggests it might be more; and what the buyers can afford before they start to suffer from mastitis. The essential instability to finding equilibrium there is the conflict between the luxury of governments subsidizing imports of oil, which is something that both USA and China do, and the un-sustainability, long term of financing current expenditure on the luxury of cheap gasoline, by borrowing, rather than by investing in infrastructure to lower costs in the future.

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That’s a simple chart – it’s not a big secret, you can look the numbers up on Wikipedia if you don’t believe me, USA and China need over twice as much oil to generate a unit of GDP that countries that have policies to increase the return on investment on every barrel they burn. The main policy there is taxation:

Source OPEC: http://www.opec.org/opec_web/en/data_graphs/333.htm

I remember years ago asking someone how the population put up with Franco. He told me “It’s simple, cigarettes and alcohol are cheap”… in USA it’s the same deal, except over there the fascists use gasoline prices to keep the masses happy. If USA had the same tax on oil as Europe, that would generate another $500 billion a year, which is, if you think about it, enough to run a decent sized war, even these days.

3: A third school of thought has it that speculators are manipulating the market, which is what the Saudis have been saying all along (they said it was a Zionist Plot). You have to give credit to the Saudi’s role of “fairy-godmother of last resort” in this whole scenario, when there is a bubble they pump, and the reason they give is that if they don’t the world economy will stall.  They could be right:

Put this one on your iPhone and weep:

So you say the financial collapse was caused by Lehman? Oh yeah…but something happened before that, nominal GDP growth in USA was half-way to the bottom before Lehman hit. The red line there by the way is a rough & ready estimate of the “fundamental” as defined by FOOT = 3.3% x TOAD/OIK, assuming that over that period the supply was pretty much constant (i.e. the line is defined by nominal GDP).

What that all says to me is that (a) on one hand as argued in my previous article the fundamental is driven by the line of nominal GDP when supply is more or less constant (b) but equally nominal GDP (or growth of that) is driven to some extent by the degree of departure of the price from the fundamental, so there is a feedback-loop working there, and as we all know from Engineering-101, when you have feedback loop you get oscillations, and sometimes those can shake your contraption to bits…like now. Oh yeah, you thought I was asleep, nope…I know about the spread between WTI and Brent, but that only started recently, and what America pays to import oil is dictated more by Brent and the OPEC basket which more or less tracks that.

How about this one:

Looks suspiciously like when USA starts to have to borrow over $125 billion a quarter from foreigners so they can pay for their “habit”; the train goes off the rails. I haven’t updated that chart, but the excess over “fundamental” paid by America in the current oil bubble, is more than they paid out (borrowed) in the last one. So how about this one:

Looks suspiciously like the departure of oil prices over the fundamental correlates pretty well with a drop in nominal GDP growth in America. Make no mistake, it’s not “real-GDP” that matters in a time of deflation, it’s nominal, how much of the nominal is inflation is something to worry about later. 


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26 Comments on this Article show/hide all

emptyend 31st Aug '11 1 of 26
11

Some interesting thoughts in there. I suspect that this is the key one re oil:

Another school of thought has it that there are now constraints in production of oil, and prospects of further constraints as oil is currently getting discovered and developed, slower than the rate at which it is being used. Another way of saying that is that the replacement cost, i.e. the cost of finding new oil and bringing it to market, is what determines the correct (i.e. fundamental) price. I would like to emphasize that “replacement cost” is not the cost of pumping oil that has already been found out the ground, it is the cost of finding an equal quantity of oil that hasn’t been found yet, and pumping that to the market.

I suspect that true replacement costs are very much higher than the number you quote from Exxon. $75 might be Exxon's number - but it won't be the number for the world as a whole. One important aspect is the cost of developing new technologies - and that seems to be ever-rising.

There are three other factors that I think are important:

a) the breakeven oilprice that is subsumed into the Saudi Government's budget......I've seen reports that this is as high as $100 for 2015. The cost of keeping the peace in the middle East is rising - mainly because the cost of buying-off the local populations is rising!

b) I strongly suspect that without the ever-growing government borrowing in the western world over the last 30 years, growth rates would have been considerably lower (I'll leave it to economists to try to put numbers on it). We are now seeing that multi-decade pattern of pump-priming being forced into the buffers - and that in itself will have a material impact on growth (and indeed may force new aims on government policy which are not as growth-oriented). I can't quite understand why economic growth per se is considered a good policy objective.

c) The elephant in the room is the ability of Saudi Arabia to continue to fill supply shortfalls. Whether they will struggle to maintain political control or whether it will simply be that Ghawar eventually comes off plateau (as forecast by Simmons in 2004), I really don't know. But the Saudi's present "swing producer" status simply won't be sustainable indefinitely.

ee

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tournesol 31st Aug '11 2 of 26
17

I take exception to Mr Butter's repeated description of the US as "fascist".

The various definitions of that term which come readily to hand - Oxford Dictionary, Wikipedia - bear little or no relationship to the US. America's government, society and civil institutions are all completely at odds with those found in fascist states.

More to the point, in common parlance "Fascism" implies a system of corrupt dictatorship which oppresses/suppresses its own populace and conducts vicious aggressions against those it designates as its enemies, be they internal or external. These lead to genocide.

I would not object to the description of China, Syria or Saddam's Iraq as Fascist, to name but three. But I can't for the life of me recognise the US as anywhere remotely close. That's not to say it is a perfect liberal democracy. But its faults should not be over-stated.

To call the US fascist is to demean that term and to under-rate the suffering of people crushed by real fascist states.

I note Mr Butter's connections with Gulf States. I wonder how tolerant the Saudis would be if he called them Fascists whilst living there. In the US of course the constitution would guarantee him freedom of speech which he would be allowed to use to attack and slander the State. I think that speaks for itself.

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Andrew Butter 31st Aug '11 3 of 26

In reply to emptyend, post #1

a): I agree the replacement cost is likely much more than $75, that was put out as a low number, the high number is what it costs to reliably drill for oil in middle of the Atlantic, that's pretty much anyone's guess and fairly academic whilst some countries just pump as much as they can, often so that the people in power can take the money and run.

The cost of keeping the "peace" in the Middle East has nothing to do with oil, it's the cost of protecting Israel maintaining their luxury of intransigence.

b): It wasn't government borrowing in USA that created the illusion of wealth (and sustainable GDP), it was, certainly over the past ten years, the machine of securitization.

c): You are correct that Saudi cannot be the "swing" producer for long, also their oil is high in sulphur and the market is splitting; don't "worry" about political control.

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djpreston 31st Aug '11 4 of 26
5

In reply to Andrew Butter, post #3

The cost of keeping the "peace" in the Middle East has nothing to do with oil, it's the cost of protecting Israel maintaining their luxury of intransigence.

Really?

Whilst Israel is its own enemy, the repressive regimes (and some of the less repressive ones) across the MENA area have taken a look at what happened with the revolutions and decided that its in their own best interests to throw some "crumbs" to the masses to keep the ruling elite in control.

Looking at the demographics of many of the ME countries (huge very young populations and mass unemployment) you can see the scope for further unrest. Unfortunately, the only way to do that is to maintain high oil revenues to pay the "bribes". Add to that the massive rise in consumption in Saudi and its reduced scope for export supply and oil prices are going to remain high for quite some time.

Ideally a fall back to a more "acceptable" $80 say, would benefit global GDP but hurt those much needed ME revnues and what happens if/when the Saudi "masses" rise up and overthrow? Look at previous examples of revolutions in oil producing countries to see how long (if ever) it took to get production back to pre revolution levels.....

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Andrew Butter 31st Aug '11 5 of 26
13

In reply to tournesol, post #2

I apologize if I caused offence – that was not my objective.

Skimming through Wikipedia, some random quotes:

“Historians, political scientists and other scholars have long debated the exact nature of fascism. Each form of fascism is distinct, leaving many definitions too wide or narrow”.

“George Orwell wrote in 1944 that "the word 'Fascism' is almost entirely meaningless ... almost any English person would accept 'bully' as a synonym for 'Fascist'". Richard Griffiths argued in 2005 that "fascism" is the "most misused, and over-used word, of our times".

The part that best reflects my use of the word was:

“Fascists believe that a nation requires strong leadership, singular collective identity, and the will and ability to commit violence and wage war in order to keep the nation strong”.

So perhaps what the word means to you is not the same as what the word means to me, genocide is a common result of fascism, but that's not obligatory and plenty of other political persuasions practice genocide.

With regard to your view that I am somehow "demean" the great liberal tradition of America by using the word fascist, and that somehow I do not acknowledge the atrocities of fascist governments, that is not correct. My father, his brother and my cousins fought fascist Germany one was killed, one got a Military Cross, I am proud of that.

But perhaps you forget that America has not signed up to either Protocol One of the 1977 Geneva Convention (that’s the one about protecting civilian populations in times of war), or to the International Criminal Court which is supposed to prosecute alleged war criminals. Living in the Middle East as you have noticed I do, and hearing first hand accounts of the conduct of the US Military, I regret that I disagree with your romantic ideas on the essential “goodness” of American Military power.

With regard to what I might say about the country I live, well actually I do say and write a lot, although you are correct, I am careful not to cause offence. But actually, I find it easier to say hard things here, than it is to say hard things about America in American media, freedom of speech requires freedom of the press, and if you think the US press is free, you are naive.

More to the point I happen to believe that the particular place I live, the UAE is a very well governed and tolerant country which takes it’s obligations to the world community very seriously. Also, incidentally, it hands out more money in aid to poor countries, per unit of GDP, than any other country in the world. My main beef about the UAE is that they waste money.

With regard to Saudi Arabia, in my view Saudi is also well run, in the circumstances (which include having to contend with a part of the population that has very strong religious views), and that the efforts that the Saudi Government has made to mitigate against oil bubbles which are, as I have argued, very damaging to the world as a whole, should be commended.

I’ll go one further, in my opinion Saudi Arabia should be invited to have a permanent seat on the U.N. Security Council after all, it represents more than any country in the world the Muslim religion, which is not represented at all on that council, and the track record of the government as a pragmatic facilitator of peace, is good, you forget perhaps that the Saudi's were close to finalizing a deal to get the Taliban to hand over Bin Laden, when 9/11 put an end to negotiations.

I have lived in USA, and in Saudi, in my opinion ordinary people in Saudi Arabia are better treated and cared for by their government than ordinary people in America, and the "guest workers" who reside there temporarily, are infinitely better treated in Saudi than the "wet-backs" get treated in USA.

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emptyend 31st Aug '11 6 of 26
8

In reply to Andrew Butter, post #3

The cost of keeping the "peace" in the Middle East has nothing to do with oil, it's the cost of protecting Israel maintaining their luxury of intransigence.

I'm afraid I completely disagree with that and completely agree with djpreston's response to you. Israel is a big factor regionally - but the major pressures facing their neighbours now are internal, now that the so-called "Arab Spring" genie is out of the bottle. It is ridiculous to say that the vast increase in Saudi Government spending that this has prompted has no implications for the oil price!

b): It wasn't government borrowing in USA that created the illusion of wealth (and sustainable GDP), it was, certainly over the past ten years, the machine of securitization.

Certainly securitisation ramped up the illusion of wealth to a whole new level, but the cultural change that preceded that period (and which created the conditions for the vast mushrooming of personal, corporate and government debt) was that governments no longer worried too much about debt levels - and that fed through into encouraging individuals not to worry much about it either. It was a "madness of crowds".

One of the interesting things is the calls in the West from many of the rich themselves for taxes to be raised on the rich. They didn't get where they are today by being stupid....and they can see which way the wind is blowing. Not only is is morally right for the rich (and ruling elites!) to pay their fair share - but it is very important for them to be seen to be doing so.....because if they aren't then they risk losing it all through uprisings!

ee

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About Andrew Butter

Background  technology-orientated EPC (1980-90), market research (1990-2000) and real estate development management  (2000-2005), currently doing ad-hoc interim management mainly relating to turnarounds and start-ups. Based in Dubai, degree in bio-resource engineering.   more »


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