Page 3 of 4 Flat-earther blind to oil facts
By Henry C K Liu
but the formula depends more on the price gap between import and domestic oil,
which in a global market is not expected to stay wide for long. The idea of
achieving oil independence as a strategy for cheap oil is unworthy of serious
discussion.
The economics of petroleum is as important as geology in coming up with reserve
estimates since a proven reserve is one that can be developed economically. But
it is important to remember that political economy extends beyond the supply
and demand fixation of market fundamentalists. If the Middle East and the
Persian Gulf implode geopolitically and oil from this region stops flowing, the
US, as an oil producer will be a main beneficiary of $50 oil, or $100 oil, or
even $1,000 oil, as would Britain with its North Sea oil
and countries such as Norway, Indonesia, Nigeria and Venezuela. But the biggest
winner will be Russia.
For China, it would be a wash, because China currently imports energy not for
domestic consumption, but to fuel its growing export machine, and can pass on
the added cost to foreign buyers. In fact, the likelihood of the US bartering
below-market Texas crude for low-cost Chinese manufactured goods is very real
possibility in the future. Similar bilateral arrangements between China-Russia,
China-Middle East/Gulf, China-Nigeria, China-Venezuela and China-Indonesia are
also good prospects. Also, China�s off-shore reserves have so far stayed
largely undeveloped.
Fact 10: $50 oil bought the US debt bubble a little more time, but
bubbles never last forever and it burst in August 2007. But in a democracy, the
White House in 2005 was under pressure from a misinformed public to bring the
oil price back down to $25, not realizing that the price for cheap oil could
accelerate the bursting of the debt bubble. Despite all the grandstand warnings
about the need to reduce the US trade deficit, a case can be made with ease
that the United States cannot drastically reduce its trade deficit without
paying the price of a sharp recession that could trigger a global depression.
The economics of oil
Since the discovery of petroleum, its economics has never been about cutting a
square deal for the consumer, corporate or individual, let alone the little
guys or the working poor. It has to do with squeezing the most financial value
out of this black gold.
John D Rockefeller consolidated the US oil industry into a monopoly by
eliminating chaotic competition to keep the price high, not to push prices
down. Neo-classical economics views higher prices of consumables as inflation,
but asset appreciation is viewed as growth, not inflation. Since oil is both an
asset and a consumable commodity, neo-classical economics faces a dilemma in
oil economics. The size of oil reserves is exponentially greater than the
annual flow of oil to the market.
What is even more fundamental is that as the flow of oil to the market
decreases, the price of oil goes up, enlarging proven reserves by definition.
Thus while a rise in the market price of oil adds to inflation, the
corresponding rise of the asset value and size of oil reserves create a wealth
effect that more than neutralizes the inflationary impact of market oil prices.
The world should not care about an few added percentage points in inflation if
the world�s assets would appreciate 100% as a result, except that when
oil is not owned equally among the world's population, a conflict emerges
between consumers and producers, making oil a domestic political and
geopolitical problem.
In fact, on an aggregate basis, cheap oil can have a deflationary impact on the
economy by reducing the wealth effect of all assets. For the US economy, since
the United States is a major possessor of oil assets, both on- and off-shore,
high oil prices are in the national interest. What we have is not an inflation
problem in rising oil prices, but a pricing problem that distributes unevenly
the benefits and pains of price adjustments among oil owners and oil consumers,
both domestically and internationally. This is a political problem. Politicians
are under populist pressure to keep oil prices low when the solution is to
equalize the benefits and pain of high oil prices.
Oil price and monetary policy
Failure by OPEC to cut production at its meeting in November 1998 prompted
prices to collapse to a 12-year low of $10.35 a barrel in New York the
following month. A combination of excess production, rising inventories and
poor demand for winter heating fuels pushed prices down. In March 1999, oil
prices climbed 17%, going higher as oil-producing countries, unified by low
prices, succeed in cutting output. Oil prices began making a sharp recovery in
the late winter of 1999, rising from the low teens at the beginning of the year
to more than $22 a barrel by the early autumn, and crossed $30 a barrel in
mid-February 2000. A major cause was production cuts settled upon in March 1999
by OPEC and other major oil-exporting nations.
On March 12, 1999, St Louis Federal Reserve Bank president William Poole said
in a speech that the growth of the US money supply, which was then at more than
8% when inflation was below 2% annually, was "a source of concern" because it
outpaced the rate of inflation. The M2 money supply had been growing at an 8.6%
annual rate for the previous 52 weeks to keep the economy from stalling before
the 2000 election. The US Federal Reserve was also watching the rate of
inflation, held down mostly by low oil prices.
Poole warned that "we cannot continue to rely on the decline of oil prices at
the [low] pace of the last couple of years". He said investors who had pushed
bond yields to their highest level in six months were correct in assuming the
Fed�s next move would be to increase interest rates. The Fed Open Market
Committee (FOMC), when it met on February 2, 1999, had left the Fed Funds rate
(FFR) target unchanged at 4.75%. Poole voted in 1998 for the FOMC to cut the
FFR target three times between September and November to 4.75% when oil was at
$12.
Today, with oil at around $135, the FFR target is 2% effective since April 30,
2008. On June 25, the Fed opted for keeping the Fed funds rate target
unchanged. In its statement, the Fed Open Market Committee (FOMC) said: "Tight
credit conditions, the ongoing housing contraction, and the rise in energy
prices are likely to weigh on economic growth over the next few quarters."
Annualized growth rate for M2 in Q4 2007 was 6.8%, with a Fed funds rate target
of 2%, as compared with the 1999 M2 growth rate of 8.6% against a Fed funds
rate target of 4.75% in response to fallouts from the 1997 Asian Financial
Crisis. However, in the past seven quarters before end of 2007, V2 (the
velocity of M2) declined by 2.3% annum rate, causing GDP growth to decelerate
from 3.5% to 2.2%. GDP growth for Q1 2008 was 0.6%, which justified a 2% Fed
funds rate target.
Yet if the Fed is really concerned with fighting inflation expectation, $135
oil and 2% Fed funds rate target simply do not mix, even with a falling
money-supply growth rate. There is strong evidence that instead of worrying
about inflation expectation, the Fed is really more worried about the economic
debris from the burst debt bubble, which stealth inflation through asset
appreciation is expected to help clean up with less pain.
If high oil prices are the handiwork of speculators, the Fed is the
speculator-in-chief. But there is very little speculation in the oil market
because hedging is not speculation as all competent market analysts know. The
rise in oil price is the direct result of a debasement of money coordinated by
the world�s central banks led by the Fed.
In July 1993, when the US economy had been growing for more than two years from
M2 growth of over 6%, then Fed chairman Alan Greenspan remarked in
congressional testimony that "if the historical relationships between M2 and
nominal income had remained intact, the behavior of M2 in recent years would
have been consistent with an economy in severe contraction." With the M2 growth
rate down to 1.44% in July 1993, Greenspan said, "The historical relationships
between money and income, and between money and the price level, have largely
broken down, depriving the aggregates of much of their usefulness as guides to
policy. At least for the time being, M2 has been downgraded as a reliable
indicator of financial conditions in the economy, and no single variable has
yet been identified to take its place."
Yet M2, adjusted for changes in the price level, remains a component of the
Index of Leading Economic Indicators, which some market analysts use to
forecast economic recessions and recoveries. A positive correlation between
money-supply growth and economic growth exists only on inflation-adjusted M2
growth, and only if the new money goes into new investment rather than as debt
to support speculation on rising asset prices. Sustainable economic expansions
are based on real production, not on speculative debt.
In 2004, longer-term interest rates actually declined from their June high of
4.82% to 4.20% at year-end even as short-term rates rose in a "measured pace"
to 2.25% in December 2004 (from all time low of 1% in June 2003 to 5.5% in June
2006), with the 2004 money supply growing at a 5.67% annual rate. This
reflected a credit market unconcerned with long-term inflation despite a
sinking US dollar and oil prices rising above $50 a barrel. The reason is that
$50 oil raised asset value at a faster pace than price inflation of
commodities. $100 oil only doubles the impact.
In March 2000, OPEC punctured the Greenspan easy-money bubble by reversing the
fall of oil prices. The FOMC was forced to respond to the change in the rate of
inflation, no longer being held down by declines in oil prices. Because the
easy money had stimulated only speculation that did not produce any real
growth, the easy-money bubble of 2000 evolved into the next debt-driven asset
bubble in housing that burst in August 2007.
The smart money realized in 2000 that the market�s march toward $50 oil
was on, as the smart money realized in 2007 that the march towards $150 oil was
on. And in 2005, $50 oil appeared to be giving Greenspan�s debt-driven
asset bubble a second life, most of which ended in the real-estate/housing
sector. If oil should fall back to $25 a barrel as the White House wanted, the
debt-driven asset bubble would have popped with a bang.
As it turned out, the housing bubble burst from a credit collapse in
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