Page 4 of 4 Flat-earther blind to oil facts
By Henry C K Liu
August 2007 that the Fed under Bernanke tried to bail out with massive
liquidity injection and oil went on to $130. The Fed now appears to be assuming
that oil prices will soon subside, based in large part on information on
futures prices. Yet there are limits to the extent to which futures prices can
indicate price trends, since arbitrage prevents them from moving very far out
of line with current prices.
There was solid evidence that the 1970s recycling of petrodollars, which mostly
ended up in the dollar assets in the United States anyway, contributed to US
inflation as much as the higher retail price of gasoline. It in essence
siphoned off additional global funds to purchase higher-priced oil for
investment in US real estate, which was the only sector the then
unsophisticated Arab money
managers thought they knew enough about to handle. By the 1990s, they were more
sophisticated. Some had expected that a new injection of petrodollars would
sustain the collapsing "new economy" equity market of the 1990s. It did not
work because, even at $35, oil was still behind its pre-1973 price relative to
the peak Nasdaq in June 1999, the equivalent of which would bring $120 oil.
The drop in oil prices after 1997 was mostly a cyclical effect of the drastic
reduction of demand from the Asian financial crisis, which impacted the whole
world. There was zero pressure even in the US to raise oil prices at that time,
because of the effect they had on keeping easy-money inflation low. Even oil
companies were not really upset by this temporary condition because, until oil
prices dropped below $7 per barrel, it was not a big deal since that was the
offshore production cost in the North Sea. The wellhead cost on land was less
than $4 per barrel, plus market-induced leasehold costs. North Sea oil was
higher because of fixed offshore drilling investments.
In 1998, oil could stay at anywhere above $7 for quite a few years without
doing any lasting harm to the US or Europe. It was widely expected to go back
up to $35 by the end of 2000, and a lot of people would get rich in the
process. OPEC was touting the line of argument that high prices would stimulate
new exploration to get the non-OPEC consumers to accept costlier oil. In the
long run, less new exploration would be good for OPEC.
Before 1973, the whole world was happy with $3 oil. As for the US, cheap oil
kept inflation (as measured by the Fed) low, the dollar high and dollar
interest rates low. These benefits outweighed the oil-sector problems created
by a collapse in oil prices. In oil, no one has told the truth for more than 80
years, or since its discovery.
The problem with cheap oil
It is often overlooked that the United States is a major oil producer. In fact,
before the discovery of oil in the Middle East in the 1930s, the US was the
world's biggest exporter of oil. "Oil for the lamps of China" was a slogan of
the Standard Oil monopoly.
It is not clear that cheap oil is in the national interest of the US. Cheap oil
distorts the US economy in unconstructive ways. In recent years of cheap oil,
advances in conservation have all been abandoned. Until this year, US consumers
were buying eight-cylinder SUVs with 400 horsepower that deliver only six miles
per gallon in urban traffic, as well as air-conditioned convertibles. Even with
$4 gasoline, commuters face only a $1,000 annual increase in their gas bills.
Vehicle prices have risen faster than gasoline prices in recent decades. Of
course, the rest of the world outside the US has been operating on $4 gasoline
for a long time.
Oil at $100 is not an economic disaster but it is a political problem.
Hundred-dollar oil needs not be damaging to the global economy, but it
nevertheless forces a restructuring of the global economy in ways that have
political reverberations. To begin with, $100 oil will in the long run
stimulate more exploration and production, and reactivate idle wells that are
uneconomic at $10 per barrel. It will also make alternative energy economically
more viable.
Also the global economy is growing more energy-efficient with new technology,
and the effect of oil price on the economy is much less than in the 1970s. And
$100 oil will prevent a return to the era of abusive waste of energy caused by
excessively low oil prices. Just as low wages encourage misuse of labor,
unreasonably low oil cost creates incentives for misuse of energy and
discourages the search for alternative energy sources.
The only trouble is that $100 oil takes money from the pocket of consumers and
delivers it to the oil producers (not just Arabs), who then reinvest it in Wall
Street. The net result is a transfer of wealth from the "working families" of
the world to the capitalists the world over. Consumer demand will shift, with
more money spent on fuel and utilities and less for other types of consumption
that improve the standard of living, but equity prices will rise because there
will be more dollars chasing the same number of shares.
What is more troubling is that the appreciation of the resultant enlarged
proven oil reserves will fuel more debt at the same debt-to-equity ratio. The
current structure of the overcapacity economy is such that more debt can only
go to support consumption and speculative, not productive, investment, causing
a new unsustainable debt bubble.
A reduction of oil taxes will leave more money in consumers' pockets.
Governments can make up the resultant tax shortfall by increasing tax rates on
oil-asset appreciation - perhaps, in the case of the United States, to fund the
coming Social Security shortfall. But governments tend to resist fuel-tax
reduction because of the flawed ideology that fuel taxes encourage
conservation. Capital-gain tax measures are resisted on the doctrine that what
hurts capital hurts the poor also, if not more. This ideological fixation is
increasingly inoperative in a world saddled with overcapacity and widening
income disparity.
Any development that reduces demand is deadly for the current global economic
structure. Therein lies the key issue of the coming oil crisis - ballooned
equity prices unsupported by wage income and a dampening of consumer demand due
to high prices. The world enjoyed a boom from $10 oil for a decade. During that
boom, income disparity increased both domestically and globally. Now, a return
to operative market price for oil should not be allowed to continue this trend
of widening income disparity.
I wrote in 2005: "We now appear to be heading toward a replay of the early
1980s when a widening trade deficit and a precipitous fall of the dollar
triggered the 1987 collapse of the equity markets. Greenspan�s strategy
of reducing market regulation by substituting it with crisis intervention is
merely swapping the extension of the boom for increased severity of the bust
down the road. Greenspan appears to be looking to $50 oil to sustain his debt
bubble. While $50 oil is not a problem in the long run, it could give Greenspan
a super-size headache if it serves merely to fuel more debt. Greenspan started
his tenure at the Fed with a market crash. Will the wizard of irrational
exuberance end his tenure with another market crash?"
My question was answered two years later by the 2007 credit crisis, and even
the Fed now is saying the market will not see a bottom until the end of 2009.
Henry C K Liu is chairman of a New York-based private investment group. His
website is at http://www.henryckliu.com.
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