Accenuate the Positive

Oil, oil, oil. It seems that all Americans talk about is the price of oil and the negative impact it has on our economy. Although oil prices will not decline in the near future, Gary Shilling shares his optimistic outlook…

Crude oil prices have soared this year for many reasons: Global demand is rising at an estimated 2.4% annual rate, well above the past decade’s average of 1.7%, while worldwide excess capacity has almost disappeared. Furthermore, terrorist threats in Iraq and elsewhere have added a premium to oil prices that some estimate in the $5-10 per barrel range. Then there is the speculative premium. As with many markets in recent years, hedge funds and other speculators are exerting strong, if not dominant, influences that may account for $3-9 per barrel of crude oil’s current price.

Given the current U.S. crude oil consumption rate, each dollar per barrel costs the American economy about $7.5 billion per year. So if prices are, say, $20 per barrel above the ex-terrorism, ex-speculation equilibrium, that amounts to an extra tax of $150 billion annually, or 1.4% of GDP. Considering the markups, as crude oil is converted into various products and sold to final users, the increased cost is closer to 2% of GDP.

Looking at it from another perspective, rising energy costs have added about one percentage point to overall inflation in the past year. So consumer purchasing power has been reduced by about 1%.

In addition to fearing that the recent oil price leap will sink the economic ship, some fear that expensive energy will persist indefinitely, while others believe that worldwide production will top out in the next decade or so.

Crude Oil Consumption: No Significant Substitutes

They are convinced that no big, economically feasible oil fields remain to be found. Nor do they expect natural gas, liquefied natural gas, the tar sands in Alberta, heavy oil in Venezuela and elsewhere, oil shale, coal, hydroelectric power, nuclear energy, wind, geothermic, solar, tidal and biomass energy, fuel cells, etc., to substitute significantly for petroleum.

I believe this is far too pessimistic of an outlook. Continual technological improvements make the discovery of big new fields, and increased production from existing ones, likely. Nonpetroleum energy is also sure to be exploited.

In any event, the sizable cost to end users of the recent leap in petroleum prices is not the whole story, especially when it is projected forward into economic disasters. Oil demand develops slower than global real economic growth, and this declining trend in oil consumption in relation to GDP is, of course, due to greater efficiency in energy use. It is also due to the increasing share of GDP, especially in developed countries, accounted for by services and the declining shares of goods, including petroleum. These depressing forces will continue and probably intensify.

The declining importance of energy in GDP production in the United States and most other countries means that the current crude oil price leap is less significant than previous spikes and should do less damage to the economy.

Furthermore, petroleum’s share of U.S. energy consumption has fallen since the late 1970s. At the same time, natural gas, which is important for residential heating, electricity generation and manufacturing and accounts for about 30% of energy usage, is more expensive than in 2002 and 2003, but has seen price declines in recent months, even as crude prices leaped.

Crude Oil consumption: The Net Effect on the US Economy

On balance, then, the recent spike in energy prices has many effects to consider in assessing the net effect on the U.S. economy. Crude oil prices are still well below earlier peaks in real terms. Furthermore, some of the increased energy outlays are recycled back into the U.S. economy, but fewer proportionally than earlier, because much more U.S. energy is imported now. Of the money that stays in the U.S. economy, the substantial shifts from energy users to domestic producers, hedge funds and others can be highly disruptive. Most important, the net "tax" by energy-exporting countries on U.S. energy users is still large.

A final factor to consider is the chance that oil prices will fall meaningfully, and they did fall in the latter part of August and into September. The fact that their rapid rise and lofty level are spread all over the media today suggests that a peak is near. So do the decisions of a number of global banks, in their normal herdlike fashion, to get into oil trading and hedging services.

On balance, will all these positives and negatives largely cancel out, leaving the recent spike in oil prices of little significance to the U.S. economy and the world? Or will the negatives prevail and seriously disrupt economic growth?

To begin to answer these questions, note that crude oil prices are unlikely to see a big decline anytime soon. This time, however, the Saudis and other producers don’t have enough excess capacity to influence oil prices much. And although that $3-9 per barrel speculative premium on crude oil prices might disappear, as any meaningful decline sends speculators running to unload their highly leveraged positions, a big price break below around $40 per barrel seems unlikely. The terrorism premium will still be with us, and oil supplies are unlikely to rise significantly in the near future.

It isn’t that producers aren’t being spurred by very attractive current prices to increase capacity, despite the reluctance of the major Western oil giants. Drilling activity in North America, the Middle East and the former Soviet Union is rising. Kuwait may soon allow foreign oil companies to invest in her oil sector, pressuring other Middle East producers to follow. The Saudis have plans to increase production to 12 million barrels per day, or even 15 million, from the current 10.5 million. Russia, in particular, is keen to increase oil production since petroleum exports are the basis of her current economic growth and the primary source of foreign exchange.

Crude Oil Consumption: Dire Forecasts

Ultimately, all of these efforts to increase petroleum supplies will likely be successful. While I don’t agree with the dire forecasts of the crude oil pessimists, it does take time, anywhere from two to 10 years, to get oil fields developed. And meanwhile, little production capacity remains unutilized.

Furthermore, even a substantial crude oil price decline probably wouldn’t help the U.S. economy much. As discussed earlier, the economy is much less dependent on energy than during earlier oil price spikes, and real crude prices are still far below previous peaks. So a big drop would be far less meaningful than in 1986, for example. In addition, American consumers are near exhaustion, so it would take much more than cheaper gasoline to reinvigorate them. They’ve long since spent their tax cuts and the money they received from cash-out mortgage refinancing. They’re heavily in debt, and many face bankruptcy.

Energy supplies are unlikely to rise enough to precipitate a big crude oil price decline in the near term. True, there is some talk of tapping the strategic oil reserves of developed countries, which totals 1.4 billion barrels, 666 million of which is in the United States. But the idea is to scare the petroleum speculators, not to become a longer-term source of oil supply. Plus, the Bush administration continues to reject this idea

If today’s U.S. economy were strong, the petroleum price spike probably wouldn’t be enough to depress activity appreciably, but that’s not the case. Ironically, oil prices will probably fall substantially in the next year or so, but only because of the reduced demand that accompanies economic weakness in America and abroad.

Besides squeezed consumers, global capacity gluts, terrorism fears, Fed tightening jitters, high energy prices, a softening stock market and uncertainty over the presidential election are also of concern. Furthermore, the Fed is raising interest rates, and almost always the final result is a recession.

On balance, then, the recent spike in crude oil prices is not nearly as devastating to the world as were earlier oil shocks, especially those in the 1970s. Nevertheless, given the basic weakness in the U.S. economy and China’s determination to cool excessive investment, the "tax" that energy-exporting countries are collecting from American energy users may be big enough to precipitate a recession in the United States that will spread globally, especially if China has a hard landing. That would be the sixth consecutive time that a jump in crude oil prices provoked an American business downturn.


Gary Shilling
for The Daily Reckoning
October 20, 2004

Neither the Dow nor the dollar are doing George W. Bush any favors. With just days to go before the election…both are slipping. Presidents are not usually re-elected when the Dow goes down. But who knows…a lot can happen in two weeks.

Nothing had happened for a long time. We were surprised, because we thought something would happen before now. But the longer nothing happens, the more people begin to think that nothing is not just a passing phase, but eternal. That is why the VIX is at multiyear lows – people are not buying put options to protect themselves; they see nothing to protect themselves from. The spread between corporate bonds and Treasury bonds has also narrowed to multiyear lows. Investors figure nothing will go wrong with the corporate bonds, so why ask for a premium?

But nothing really is eternal – something always happens. And when it does happen, we are all surprised again, and money changes hands.

Nobody makes money when markets do what everyone expects. You make money only when the markets do what you expect and surprises the person on the other side of the trade. You make a lot of money when markets do what you and a few others expect and nearly everyone else is surprised.

We watch the dollar. The greenback surprised virtually everyone by not falling over the summer. Richard Duncan sent an e-mail yesterday explaining why. The world financial system has become so perverse that the dollar now rises along with the current account deficit! What a surprise. Everything we thought we knew about macroeconomics tells us that the dollar should fall as more money goes out than comes in. But Duncan points out that the key now is not the raw deficit figures, but the deficit as it relates to sales of U.S. debt instruments. Those overseas dollars are now recycled into U.S. debt (they are used to buy U.S. Treasury bonds and notes). If the amount of debt issued goes down – as it did in the spring and summer – the result is more money chasing fewer goods (debt). Debt (bonds) goes up in price…along with the currency in which they are calibrated (dollars).

This is, of course, not a permanent situation. It works only as long as U.S. dollars are recycled into U.S. financial assets. Net capital flows to the United States are actually slowing down. They’ve fallen in each of the last six months through August. From July to August, the amount was cut in half. The Chinese, we hear, are switching to European assets…and to the euro.

The day before yesterday, the euro seemed to rise out of its summer trading channel. The dollar fell below $1.25/euro. Yesterday, the trend continued.

What happens next? We don’t know. No one knows. But a lot of people are bound to be surprised.

Over to our news team in New York:


Tom Dyson, reporting from New York…

Mr. Roach goes to Washington…the IMF’s view of China…to find out what else is in store for you in today’s Rude Awakening.


Bill Bonner, back in London:

*** In Florida, colleague Steve Sjuggerud tells us that everyone talks about making money in real estate.

"Quick quiz for you," he writes. "What year was it? Miami had 25,000 realtors, the price of a beach lot was $800,000 (in today’s dollars), and a summer issue of The Miami Herald was over 500 pages. Believe it or not, it was the summer of 1925.

"South Florida’s real estate boom in the 1920s ended very badly. Some coastal real estate in Florida today bears a resemblance to the 1920s boom, and even to the tech stock boom of the late 1990s.

"On my island here in Florida, whenever you ask well-off folks around here what they do, they all say the same thing: ‘I’m in real estate.’ The truth is nobody’s talking stocks anymore.

"If you’re not ‘in’ real estate, you’re supporting the real estate business around here…contractors, banks, architects, builders, etc. Outside of tourism, there is no other business here. Just like Miami in the 1920s.

"South Florida’s bubble in the 1920s ended quickly. In the fall of 1926, two hurricanes came. On September 18, 1926, 400 people died and many thousands were injured, as the hurricane ripped roofs off of houses and tossed elegant yachts into the streets of Miami.

"Oceanfront lots probably didn’t hit $800,000 in today’s dollars in south Florida again until the 1980s…so it would have taken at least 60 years for someone who bought at the top to break even.

"It ‘feels’ like Nasdaq 4,000 right now here on my island…we’re not far away from the peak of Nasdaq 5,000…"

*** And a Daily Reckoning reader from Canada:

"Actually, I work for GMAC here in Halifax, Nova Scotia.
The stink of it is that you are absolutely correct. Our branch manager announced recently that GMAC is contributing most of GM’s profits. Everyone seems to be proud and elated. I, on the other hand, was immediately concerned upon hearing this chest beating, ‘look at how great we are doing,’ peacock strutting, boasting. People just don’t seem
to get it. What happens when rates rise?

"Financing is a give-away scheme right now, but it won’t be forever. You and I and few others know that manufacturing is a must for long-term prosperity. This is one of the reasons why I have become an avid and eager investor in all that is real, primarily gold and gold stocks. The future does not look bright for the dimwitted."

*** Editor thought: Does the future ever look bright for the dimwitted? Nature, in her majesty, smiles on the dim and the bright – but not at the same time. The dim do well toward the end of a trend. As they pile into an investment in the last stages of a bull market – prices rise. For a while, they seem like geniuses. Then the trend reaches its peak, and they fall down the other side like tourists rolled of the cliffs of the Grand Canyon; the bright lean over with broad grins and yell – "I told you so."

But Nature does not spare the bright, either. They feel very content with themselves when the market hits bottom. The dim are ruined. Then when prices begin to move up again, the bright hold onto their gold…and miss the biggest bull market in their lifetimes.

As Uncle Remus used to say: "Dere’s dem dat’s smart an’ dere’s dem dat’s good."

Here at The Daily Reckoning, we will put our money on "dem dat’s good." If they don’t win…well, too bad. They should.

The Daily Reckoning