http://www.atimes.com/atimes/Global_Economy/JF28Dj05.html

Jun 28, 2008

..............

................

In 2005, I listed 10 new economic facts created by $50 oil. I now adjust these facts for $100 oil as proposed by Friedman to see if his proposal makes sense. The key fact is that while $100 oil may stimulate development of alternative energy modes, such development cannot be expected to bring the oil price back down, or the stimulated alternative energy sector will go bankrupt. While there is no known solution that will lead to lower oil prices short of a global recession, $100 oil is not without problems.

Fact 1: Oil-related transactions involving the same material quantity involve greater cash flow, with each barrel of oil generating $100 instead of $25. The United States consumed in 2007 about 22 million barrels of oil each day, about 25% of world consumption of 87 million barrels. China consumes 7.3 million barrels per day. Yet daily world production is only about 85 million barrels, leaving a deficit of 2 million barrels[a day], which are being made up from inventory. That fact is the fundamental reason why oil prices have risen.

It can be expected that production will increase as a result of high prices to remove the supply deficit. US consumption has been fairly constant in the past few years. About 10.2 million barrels were imports and only 5.5 million barrels from OPEC. At $100 a barrel, the aggregate oil bill for the US comes to $2 billion a day, $730 billion a year, about 5.6% of 2007 US gross domestic product (GDP). About 50% of US consumption is imported at a cost of $1 billion a day, or $365 billion a year. Oil and gas import is the single largest component in the US trade deficit, not imports from Japan or China.

As oil prices rise, consumers pay more for heating oil and gasoline, truckers pay more for diesel, airlines pay more for jet fuel, utility companies pay more for fuel as coal price rose with oil prices, petrochemical companies pay more for raw material, and the whole economy pays more for electricity. Now those extra payments do not disappear into a black hole in the universe. They go into someone's pocket as revenue and translate into profits for some businesses and losses for others.

In other words, higher energy prices do not take money out of the economy, they merely shift profit allocation from one business sector to another. More than $365 billion a year goes to foreign oil producers who then must recycle their oil dollars back into US Treasury bonds or other dollar assets, as part of the rules of the game of dollar hegemony. The simple fact is that a rise in monetary value of assets adds to the monetary wealth of the economy.

Fact 2: Since energy is a basic commodity and oil is a predominant energy source, high energy cost translates into a high cost of living, which can result in a lower standard of living unless incomes can keep up. High energy cost translates into reduced consumption in other sectors unless higher incomes can be generated from the increased cash flow. Unfortunately, pay raises typically have a long time lag behind price increases. Higher prices translate into higher aggregate revenue for the economy and explain why corporate profit is up even when consumer discretionary spending slows. A large part of the oil problem comes from the fact that higher corporate revenue from rising prices has failed to translate into higher wages.

Fact 3: As cash flow increases for the same amount of material activities, the GDP rises while the economy stagnates from wage depreciation. Companies are buying and selling the same amount or maybe even less, but at a higher price and profit margin and with employees at lower pay per unit of revenue. As the oil price rose within a decade from about $10 a barrel to $150, a 15-fold increase, those who owned oil reserves saw their asset value increase also 15-fold.

Those who do not own oil reserves protect themselves with hedges in the rapidly expanding structured finance world. Since GDP is a generally accepted measure of economic health, the US economy then is judged to be growing at a very acceptable rate while running in place or even backwards. There is an expanding oil bubble, albeit smaller than the recently collapsed housing bubble, if one understands that a bubble is defined as a price regime that has risen beyond an economy�s ability to sustain it with compensatory income from wages.

Fact 4: With asset value ballooning from the impact of a sharp rise in energy prices, which in turn leads the entire commodity-led price chain in an upward spiral, the economy can carry more debt without increasing its debt-to-equity ratio, giving much-craved support to the residual debt bubble that began to burst before oil prices began to rise. Since the monetary value of assets tends to rise in tandem over time, the net effect is a de facto depreciation of money, misidentified as growth.

Fact 5: High oil prices threaten the economic viability of some commercial sectors, such as airlines, trucking and motor vehicles, which have exhausted their price elasticity. These sectors cannot pass on increased cost without causing their sales volume to fall. Detroit, namely Ford and General Motors, with their most profitable models being the gas-guzzling trucks and sport utility vehicles (SUVs) that can now take more than $300 to fill their tanks, are going down the same distress route as their under-funded pension obligations.

Fact 6: Industrial plastics, the materials most in demand in modern manufacturing, more than steel or cement, are all derived from oil. Higher prices of industrial plastics will mean lower wages for workers who assemble them into products. But even steel and cement require energy to produce and their prices will also go up along with oil prices. While low Asian wages are keeping global inflation in check through cross-border wage arbitrage, rising energy prices are the unrelenting factor behind global inflation that no interest-rate policy from any central bank can contain.

Ironically, from a central bank's perspective, a commodity-led asset appreciation, which central banks do not define as inflation, is the best cure for a debt bubble that the central banks themselves created with their loose money policies. Since most assets are exponentially larger than the rate of consumption, the wealth effect of higher asset value can neutralize the rise in consumer prices. This is the key reason why central banks are not sensitive to the need to keep wages rising. The monetary system is structured to work against wage earners who do not own substantial assets.

Fact 7: War-making is a gluttonous oil consumer. With high oil prices, America's wars will carry a higher price, which will either lead to a higher federal budget deficit, or lower social spending, or both. This translates into rising dollar interest rates, which is structurally recessionary for the globalized economy operating under dollar hegemony. But while war is relentlessly inflationary, war spending is an economic stimulant, at least as long as collateral damage from war occurs only on foreign soil. War profits are always good for business, and the need for soldiers reduces unemployment.

Fighting for oil faces little popular opposition at home, even though for the United States the need for oil is not a credible justification for war. The fact of the matter is that the US already controls most of the world's oil without war, by virtue of oil being denominated in dollars that the US can print at will with little penalty. Petro-war is launched to protect dollar hegemony, which requires oil to be denominated in dollars, not physical access to oil. Much anti-war posturing in an election year is merely campaign rhetoric. Military solutions to geopolitical problems arising from political economy will remain operative options for the US regardless who happens to be the occupant of the White House, populist or not.

Fact 8: There is a supply/demand myth that if oil prices rise, they will attract more exploration for new oil, which will bring prices back down in time. This was true in the good old days when oil in the ground stayed a dormant financial asset. But now, as explained by Facts 3 and 4 above, in a debt bubble, oil in the ground can be more valuable than oil above ground because it can serve as a monetizable asset of rising value through asset-backed securities (ABS) in the wild, wild world of structured finance (derivatives). So while there is incentive to find more oil reserves to enlarge the asset base, there is little incentive to pump it out of the ground merely to keep prices low.

Gasoline prices also will not come down, not because there is a shortage of crude oil but because there is a shortage of refinery capacity. The refinery deficiency is created by the appearance of gas-guzzlers that Detroit pushed on the consuming public when gasoline at less than a $1 a gallon was cheaper than bottled water.

Refineries are among the most capital-intensive investments, with nightmarish regulatory hurdles. Refineries need to be located where the demand for gasoline is, but families that own three cars do not want to live near a refinery. Thus there is no incentive to expand refinery capacity to bring gasoline prices down because the return on new investment will need high gasoline prices to pay for it. After all, as Friedman tirelessly reminds us, the market is not a charity organization for the promotion of human welfare. It is a place where investors try to get the highest price for products to repay their investment with highest profit. It is not the nature of the market to reduce the price of output from investment so that consumers can drive gas-guzzling SUVs that burn most of their fuel sitting in traffic jams on freeways.

Fact 9: According to the US Geological Survey, the Middle East has only half to one-third of known world oil reserves. There is a large supply of oil elsewhere in the world that would be available at higher but still economically viable prices. The idea that only the Middle East has the key to the world's energy future is flawed and is geopolitically hazardous.

The United States has large proven oil reserves that get larger with rising oil price. Proven reserves of oil are generally taken to be those quantities that geological and engineering information indicates with reasonable certainty can be recovered in the future from known reservoirs under existing economic and geological conditions. According to the Energy Information Administration (EIA), the US had 21.8 billion barrels of proven oil reserves as of January 1, 2001, twelfth-highest in the world, when oil price was around $20 per barrel. These reserves are concentrated overwhelmingly (more than 80%) in four states - Texas (25%, including the state's reserves in the Gulf of Mexico), Alaska (24%), California (21%), and Louisiana (14%, including the state's reserves in the Gulf of Mexico).

US proven oil reserves had declined by about 20% since 1990, with the largest single-year decline (1.6 billion barrels) occurring in 1991. But this was due mostly to the falling price of oil, which shrank proven reserves by definition. At $100 a barrel, the reserve numbers can be expected to expand greatly. The reason the US imports oil is that importing is cheaper and cleaner than extracting domestic oil. At a certain price level, the US may find it more economic to develop more domestic oil instead of importing, 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.