The high price of oil has blocked the West’s escape route

The global economy will grow by around 3pc this year, down from 4pc in 2011. The US should manage a 2pc expansion, while Britain and the eurozone will struggle. A West European recession, the UK included, now looks unavoidable. The emerging markets, meanwhile, will keep forging ahead during 2012. Even if China slows a bit, the world’s second-largest economy should expand by 8-9pc. The “big four” emerging markets – China, India, Russia and Brazil – now make up a quarter of the global economy. These “emerging giants” will account for the lion’s share of world growth in 2012, just as they did in each of the last three years.

Such countries aren’t insulated from the Western world’s sovereign debt debacle. Far from it. But with lower debts, much higher reserves, relatively stable banking systems, and trading ever more between themselves, the emerging markets will out-pace the “advanced industrialized nations” this year too.

Turn-of-the-year columns generally dwell on top-down macroeconomic forecasts. Having added my headline numbers to the predictive fray, I’d like to focus on an issue I believe will weigh heavily on the minds of Western economic policymakers during 2012- namely, the price of crude oil.

When the Western world has previously hit the economic skids, the resulting fall in global oil demand has caused crude prices to fall too. As such, the West has benefited from a “self-correction” mechanism, our own economic slowdown creating the lower oil prices that, in turn, have assisted our recovery.

During previous slowdowns, lower fuel costs have boosted the profitability of Western firms. Reduced inflationary pressures have provided our central banks with the room to cut interest rates. So cheaper oil has helped the West climb out of periodic economic slumps. Yet this vital mechanism is now broken.

Oil prices averaged $111 a barrel during 2011, up from $79 in 2010. Crude prices could stay at similarly elevated levels this year. Sky-high oil, it seems, is now compatible with Western recession. Commodity prices are compounding our economic woes, rather than help us escape them.

What’s changed recently is that even if the big Western economies remain sluggish, and our oil use falls slightly, the fast-growing markets of the East retain their insatiable appetite for crude. With per capita oil use across much of Asia still only a fraction of Western levels, and these countries engaged in the fastest, most widespread industrial revolution in human history, global oil demand keeps rising, whatever is happening in the West.

During 2011, global oil consumption averaged 89.0m barrels per day, according to the International Energy Agency, the Western world’s oil think-tank, up from 88.3m in 2010. The global economy was relatively subdued, but oil use still rose to an all-time high.

Back in 2001, global oil consumption was just 76.6m barrels daily. So during the decade to 2011, world-wide oil demand rose 16pc. We now face another sharp rise, with global usage set to reach 95m barrels daily by 2016. That would amount to a 25pc consumption increase in just 16 years.

On the supply side, global crude production expanded to 90.0m barrels daily in November, up from 89.1m the month before. In addition, OPEC crude output rose to 30.7m barrels per day, a three-year high, with Saudi Arabia and Libya accounting for most of the 620,000 barrel increase.

Last month, in addition, OPEC raised its production ceiling to 30m barrels, the first change in three years, moving the target nearer current output as the exporters’ cartel struggles to absorb rising exports from postwar Libya. But, still, despite these favorable supply-side developments, Brent crude has remained stubbornly above $100 per barrel.

One reason oil markets are tight is that inventories are very thin. Oil stocks held by the OECD group of advanced industrialized nations have lately fallen to 2,630m barrels. That’s around 57 days of forward cover, several days below the five-year inventory average. In fact, US crude inventories are ending 2011 at their lowest level since late 2008, while European inventories are now at an 11-year low.

This inventory dip reflects two important aspects of global oil production. Several of the world’s leading oil fields are losing pressure – not least Ghawar in Saudi Arabia and Mexico’s Cantarell. Two of the very biggest fields on earth, both are now producing at levels significantly below their medium-term production forecasts.

At the same time, oil-well exploration and development were hit badly by the credit crunch. Crude production is a seriously capital-intensive business with long “lead times”. In recent years, a lack of available finance has hit the oil industry hard. Getting production back “on track” will take years of heavy investment. But venture capital remains thin on the ground, not least after the Gulf of Mexico disaster led to an escalation of the oil industry’s already sizeable insurance costs.

Back in 2008, of course, oil prices fell spectacularly, from around $150 a barrel to $40. Will the same thing happen again, in the event of a “euroquake” say, or if the Western world suffers from another systemic shock? Well, if we are to face another “Minsky moment” in 2012, and we might, then oil prices could well decline rather significantly.

In my view, though, there are good reasons why the fall will be much less dramatic than last time, so less helpful in terms of rescuing the Western oil importers from an economic slump.

In mid-2008, crude markets were caught in a speculative bubble. Cheap loans were available for practically anyone who wanted to punt on oil to keep rising, which sent crude prices spiking. Today, though, the crude price is far less dependent on leveraged investment, reflecting instead the underlying demand/supply realities.

Most mainstream investors now understand that even if the West exhibits oil “demand destruction” during a severe slowdown, population pressures and rising per capita wealth in the emerging markets mean global commodity use will keep growing. This has been a difficult message to accept, seeing as Western recession now looks compatible with triple-digit oil. Yet the new reality has punched through, becoming conventional wisdom. This is very different from 2008 – when influential voices said crude would hit $10. No-one is saying that now.

Something else has happened on the supply-side too. The “Arab Spring” means that Saudi Arabia and other major Middle Eastern exporters are now running budgets with break-even oil prices above $100, needing to spend even more going forward to check social unrest. Rather than restraining oil prices, and keeping Washington happy, the world’s swing producer now has a much closer eye on domestic political concerns. So OPEC’s outlook has also significantly changed since 2008.

Another reason crude could stay high during 2012, so punishing the West even in the midst of a slump, is the currency-debasing policies those very same oil-importers are imposing on the rest of the world. For now, the “dollar standard” remains in place and the greenback remains the world’s reserve currency. Many investors, trying to take money off the table, by force of habit or regulatory dictate are still buying US government IOUs.

Increasingly, though, the smart money is moving into tangible assets, “things that governments can’t print more of”, in a desperate bid to preserve value. As talk grows of yet more US and British QE, and multiple eurozone rescue plans, mainstream money managers are increasingly looking to genuine commodities, and other expendable real assets, as a “Western debasement hedge”. So, if oil prices do remain high during a severe Western slowdown in 2012, we Westerners will in part have ourselves to blame.


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