The New Government Standard for Oil

For about three months in a row, crude oil was trading at unprecedented highs – between $90-95 a barrel. However, toward the of 2007, the oil price increases all but halted. Below, Byron King explains what occurred.

Houston investment banker Matt Simmons likes to say about oil, "Supply does not know demand." That is, in a world of Peak Oil output is going to be whatever it is. New supply is always in a race with inexorable depletion, and depletion will always win. It’s just a matter of time.

Matt Simmons or no, oil has been trading between $90-95 per barrel for about three straight months. This is an unprecedented high for the price of oil in nominal terms (adjusted for inflation, the price of oil was higher in 1979 and 1980).

But at least the black liquid has lately been trading within a defined range. Earlier in the spring and summer of 2007, oil steadily ran up from below $55 to over $90.


Demand from the developing world has been increasing, of course. And there is a growing awareness within oil trading circles of the issues affecting future oil supplies. Depletion is the other side of the coin of extraction. Depletion never takes a holiday.

Then something interesting happened. Toward the end of 2007, oil started to trade at a price plateau, drifting down as low as $85 per barrel and spiking as high as $100. Yes, the price went up and down. But in general, the base price for oil has been in the low $90s since about the end of October.

What halted the oil price increases toward the end of 2007? Lots of things.

Kevin Kerr and I have discussed this back and forth, with input from other Agora writers and numerous outside experts in the oil business. Everyone has their own answer.

As the price dip in the middle of the chart shows, the August subprime meltdown was probably the first macroeconomic phenomenon to break the upward pricing momentum for oil.

In August, a lot of people who needed to raise cash could not sell their mortgage-backed securities. If you cannot sell what you want to sell, you sell what you can sell. So people sold the most liquid things they owned, which often as not were oil and oil futures (if not gold – another story entirely).

Then, as if picking back up on the spring momentum, oil prices took off again in September and soared some more. But by late fall 2007, the second wave of the credit crunch came home to roost. Consumer sentiment went sour. Demand for refined products actually fell in the U.S. in the fourth quarter of 2007…

How long will this pricing breather last? Will the current price for oil lead to some of that so-called "demand destruction," and will the U.S. economy ever use less oil?

Well, I recently participated in a conference call with several representatives of the American Petroleum Institute. One API economist stated that the data indicate that doubling the price for oil will reduce demand by about 6%. Looking back, the price of oil has about doubled in the past year. This means that under the API model demand should have been restrained by 6% in the U.S., or more than enough to account for prices no longer rising in the past couple of months.

So for now, the price of oil has about doubled in the past year, and demand is restrained by about 6%. But will demand continue to slow down?

Our old friend Jim Rogers has his own take on things. Jim recently remarked that "It doesn’t look like $90 or $100 is going to do it" (meaning, restrain demand growth). Of course, in the short term it will take a while for people to adjust to the new reality of $90 oil.

But even in the short term some economies are craving oil regardless of a price increase.

In China, for example, there is not enough pier space for the tankers to dock and unload their cargoes of crude oil – even at $90 per barrel the imports into China aren’t slowing down.

Eventually the supply issues will come back to the fore. Jim Rogers believes that $200 oil – or even $300 oil – is possible within the next 15 years.

If you don’t believe Jim Rogers, how about the U.S. Department of Defense? No less an oil-burning institution than the DOD is planning for a future of $225, and higher, oil.

The U.S. Navy, for example, is currently designing future ships using $225 per barrel as a baseline for the price of fossil fuel. In fact, the Navy, under the direction of Congress, is also planning to use nuclear power for all future large surface combatants. And the Air Force is designing engines and fuel systems to work on synthetic jet fuels derived from coal and natural gas.

There is an astonishingly complex engineering process for qualifying synthetic fuels to work in military-grade engines, at high altitudes, high G-forces and supersonic speeds. But all of that is happening even now. The Air Force knows that it cannot lose any time in getting this done. And the Army and Marine Corps are looking hard at the fuel-efficiency of ground combat vehicles.

Post-Iraq, the Army and Marines will be re-equipping their forces with much new gear. So the planners are hard at work figuring out how to design and procure "mobility systems" that have the best possible fuel-efficiency. This is all because the DOD planners are forecasting oil prices of $225 per barrel and more.

At $90 per barrel, refiners around the world have been processing less crude oil. It is fair to say – and the ministers of OPEC have stated it repeatedly – the world’s immediate needs for crude oil are amply covered. (Well, amply covered if you enjoy paying $90 per barrel.)

In fact, one survey indicates that at least 400,000 barrels per day (bpd) of worldwide refining capacity is currently offline. On the face of it, this is the equivalent of four major refineries shutting down, at 100,000 bpd each. But in reality, it is more like 20 refineries in different regions of the world closing down partway.

What is driving these refinery closures? Refiners have idled parts of many units that process crude so they can perform routine maintenance, repairs and upgrades. This is a seasonal phenomenon. The refineries of the world have already processed the supply of heating oil for the Northern Hemisphere winter. That is, just about all of whatever heating fuel people are going to use between now and the end of March has already been processed. That fuel is in the transport system, headed to a terminal near you. So there is no large demand for more heating fuel right now.

Meanwhile, there is still time before the refineries have to start building up motor fuel stocks for the late spring and summer driving season. Thus, the refineries are engaged in rolling closures for maintenance. Without the maintenance, the refineries tend to blow up and burn down. So don’t complain.

Until next we meet,

Byron W. King
for The Daily Reckoning
February 05, 2008

Byron says that his sources tell him that gold is about to come unhinged, climbing rapidly toward an astounding new high. Before it does, imagine if you could snap up a solid position in gold, quietly, for as little as one penny per ounce. There is a way this can happen – and you can keep on doing it, no matter how high gold soars, for at least the next two years.

Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. Byron is also co-editor of Outstanding Investments, and editor of Energy & Scarcity Investor.

The Dow fell more than a hundred points. The euro/dollar exchange remained about where it was. Gold dropped back $4.10.
The news from the housing market is still grim. Home sales are falling. Inventories are building. Prices are coming down.

Consumers had been ‘taking out’ hundreds of billions in cash from their rising house values. Now, house values are falling and they’re having trouble putting it back in.

Yes, Fortune magazine reports, "Home Equity Loans Soar."

Foreclosures are rising too, of course. And now they’re in the ‘good neighborhoods,’ as well as the slums. "Big houses; Big problems," says an article in Newsweek.

Even the wealthy are said to be feeling pinched. The Orange County paper says the rich are ‘belt tightening’ along with the people who cut their hedges and fix their roofs.

But let’s not get caught up in the worms this fruit has produced…let us look at the capitalist orchard itself.

When we left you yesterday, we promised an explanation. How could it be, was the question on the table, that capitalism’s leading race should be left behind in the biggest burst of wealth-producing growth the planet has ever seen? And now, those people face a slump…maybe a recession…with no savings and no margin for error. Their government, too, is in no shape to help. President Bush will propose a budget this week – one with the biggest hole ever, a deficit of $410 billion. And if federal finances follow the pattern of the most recent recessionary period…this hole will deepen into the world’s first $1 trillion government deficit.

"I believe you mean $3.1 trillion," corrects The DR Australia’s Dan Denning.

"How can the dollar not fall when people get a load of that budget? It’s astonishing really."

"Yeah, what’s a few tril these days," chimes in Chris Mayer. "The budget is, well, shocking – even though it shouldn’t be. I mean, we all knew what was going on. In fact, as Shadow Statistics John Williams often points out, the deficit is much worse than what they are saying, because they exclude social security payments and other things. I’m sure Williams will be writing about this soon. He always does.

"At some point, the dollar gets cheap enough that foreigners feel pretty good about picking up U.S. assets. We’re already seeing this actually. Last year, foreign investors’ purchases of U.S. assets increased 93% over 2006. I think you’ll see more of that. Of course, it’s painful when you’re early. China’s purchase of Blackstone has already lost a third of its value. But, I know I’ve read about how the Chinese are eyeing U.S. timberland, for example."

How did such a lucky, rich, productive people come to this?

The background for this question is as follows:

The period 1980-2007 has seen more economic growth than any other period ever. More cars, more televisions, more highways, more hotels, more concrete, more Internet connections…just about more of everything was produced than in any similar 27-year period in history. In other terms, more money was invested and earned than ever before. And more people added more to their wealth than ever too.

The condition precedent for this explosion of wealth was that the world turned away from political change…towards market change. To the largest nation in the world, Deng Tsou Ping announced, "to get rich was glorious." All of a sudden, a billion people were bussing, humping, and schlepping – not to build a proletariat paradise, but to make money. To the north, the Soviet Union was never defeated…it simply fell apart, crushed by the weight of its own central planning. By the end of the ’80s, it too pronounced itself in favor of making money. And by the early 2000s, Moscow was the most expensive city in the world…with so many millionaires its politicians couldn’t shake them down fast enough.

Meanwhile, in Britain and America there were soft revolutions too. Maggie Thatcher and Ronald Reagan ushered in a new era where money and market solutions were said to be the cure for almost every problem. Regulations were eased or scrapped altogether. Marginal tax rates were cut. The ‘spirit of enterprise,’ as Reagan quoted writer George Gilder, would make us all rich. Those who could innovate would create new wealth. Those whom the spirit of enterprise did not touch directly could buy mutual funds. The market was the source of wealth. All you had to do was to be "in the market" and you would get rich.

For the first 20 years it almost looked true. The Dow rose 13 times from ’82 to ’00. Then, it slipped. But, with a huge in-put of new cash and credit from the financial authorities, it started up again. Meanwhile, houses went up too. After a period of 100 years when house prices only kept up with inflation, from ’97 to ’07 they shot up about 70% in real terms.

It was true, of course, that average hourly wages were lower in ’07 than they had been in the early ’70s. But people were undeniably richer, weren’t they? Stocks are much higher than they were in ’82… (Still, in inflation-adjusted terms, the person who bought stocks and held them for the last 10 years is only about even – at best.) And how many people have stocks? Savings went down during the whole period. (Why save money when you live in such a dynamic, wealth-producing society with access to so many job opportunities and so much credit?) Most people are lucky to have a few pathetic mutual funds in a 401k account. As for housing, it is more handsome and more expensive today than it was 27 years ago…but far more debt leans against it. In terms of net wealth, we have not seen any reliable figures, but we estimate that the average homeowner is poorer. Housing may be up 70%, but total debt has more than doubled. You do the math.

*** How was it possible that the world’s most privileged and advanced people did not really benefit from the Free Enterprise boom of 1980-2007?

The answer we give is this:

There is no magic to Free Enterprise. It is the best way to create wealth, but it does not prevent people from making mistakes. Capitalism offers people a chance to make money. But it also offers them a chance to make fools of themselves. Free Enterprise – like the rest of life – merely permits nature to take her course.

In a centrally planned economy people get what they deserve, but rarely what they really want. Mistakes tend to be enormous…and petty. Results vary, but experiments with central planning always end in pathetic messes.

Results vary in capitalism too. Some people tend to do very well. Others don’t do so well. Economies lurch from boom to bust, sometime favoring one group…sometime favoring another. Sometimes the farmers over-invest and go broke. Sometimes the builders over-build. Sometimes filmmakers can’t seem to make a hit. It is like life itself…an old chaos about the sun. But out of this chaos, typically, comes progress…growth…and wealth. Mistakes are made…punished…and corrected. Innovations usually fail…but sometimes succeed. The rich get richer…and then go broke. The poor get poorer…and then get lucky. No one controls the process. No one can predict its outcome…but somehow, it bumbles forward.

Occasionally, in what is basically a free-market system, a whole class of people gets the wrong idea. This is what happened in America (and elsewhere…mostly in the Anglo-Saxon economies) in the last quarter-century. They thought capitalism would make them rich, so they spent as if they already were rich. They thought jobs and credit would always be plentiful, so they saw no need to save money. Their leaders said they would prevent anything from going wrong…and the poor saps trusted them.

Instead of preventing things from going wrong with capitalism, the feds were distorting it so as to guarantee problems. A free economy, as opposed to a controlled, centrally planned Soviet-style economy, is one in which prices are set by free markets. But the feds insist on controlling the most important price of all – the price of money. They control both the quantity of money, thereby indirectly influencing the value of it; they control banking rules, which make credit relatively harder or easier to get; and they control the rate at which the central banks lends to its members, thereby setting the foundations for the whole credit structure.

After Paul Volcker left the Fed in ’86, America’s central bank began misleading the masses. Its low rates and easy lending policies – combined with the Bush administration’s reckless spending…and Asian’s reckless saving (in dollars!)…all conspired to lead the lumpenhouseholder astray. He thought he had more money than he really had. He spent more than he really should have. He saved less than he needed to. And he got what people who do those sorts of things get: a financial setback.

‘But why did his wages fall?’ you might still want to know.

Well, the easy answer is that all that ‘stimulus’ offered by the feds had quite an effect – mostly in Asia. Thanks to globalization…and Internet communications…it was easier than ever for all those Asians, finally free from communist central planning, to compete. Who were they competing with? The low…and then middle…wage earner in America. Naturally, they dragged down the cost of low- and medium-skilled labor.

‘But in Europe, wages went up,’ you protest.

Yes, they did…slightly. The standard explanation is that Europe was able to maintain wage growth by investing heavily in new capital equipment and training. European economies are ‘high cost’ economies, where employers can’t afford low-productivity jobs, because the social charges are too great. Instead, they aim for high-productivity, high-skill jobs, where the Asians haven’t been able to compete – yet. Whether this explanation is correct, we don’t know. It certainly sounds plausible. In any event, Europe has been able to keep wages high…and, until recently, has managed to maintain a comfortable trade balance with Asia.

Any more questions?

Until tomorrow,

Bill Bonner
The Daily Reckoning