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Demand destruction is on its way

Which ends first: the oil market's bull run, or the global economic recovery?

OIL PRICES are too high. Even before Libya descended into anarchy, prompting the surge in crude markets that has taken Brent to between $110 and $120 a barrel, the International Energy Agency (IEA) said the "danger zone" had been breached. By January, spending on oil imports in the rich countries of the OECD had reached levels last seen in 2008, the agency said. Global recession followed the price spike of 2008, and it could do so again. Nouriel Roubini, the economist who gained fame for predicting the financial crash, says the latest rally is particularly ominous for European economies.

The volume of extra cash now being spent by the world's biggest importers because of the latest price jump is staggering. According to data compiled by Petroleum Economist, the US' oil-import bill with crude priced at $115/b is almost $0.5bn a day more than in 2009, when the price averaged $61.70/b. Japan, India, South Korea and Germany, the next four biggest net crude-oil importers, are in total spending another $0.56bn a day more.

Such transfers of wealth were a huge drain on Western economies, and global liquidity, in the years leading up to 2008. Between 2005 and 2008, the annual fuel bill for OECD countries rose by $0.7 trillion – and more than half of that money went to Opec producers. A transfer on that scale from high-spending economies to high-saving ones created global imbalances. Now it's happening again.

Yet to listen to the arguments of some on Wall Street, the US and other big importers can afford this colossal transfer of spending (and consumer demand) out of their economies. Each week, another inflated price – $120/b, $150/b and so on – is cited as the break point when crude will begin hurting the economy. And according to some analysts those kinds of numbers aren't far away.

Investment banks, many of which take positions in the oil market, continue to issue bullish outlooks for prices this year, predicting crude's average will exceed that of 2008. Bank of America-Merrill Lynch, which previously forecast an average price of $86/b for the second quarter, now says oil will average $122/b. Goldman Sachs has lifted its forecast average price for 2011. Bears are thin on the ground.


 

But these prices do not relate to any immediate picture of the fundamentals of supply and demand – and that represents a great risk for both the oil price and the global economy. Even in southern Europe, the region most exposed to the shut-in of Libyan oil exports, people aren't queuing up on forecourts for their gasoline. The lost oil was replaced even before Libya's ports closed: Opec has been steadily increasing output since the fourth quarter of last year. The group's production is now 30.05m barrels a day (b/d), according to the IEA, with Saudi Arabia now pumping about 1m b/d over its Opec quota.

And while the Libya outage has brought Opec's spare capacity down to just over 4m b/d, world oil production of 89m b/d has reached an all-time high.

Misunderstanding these fundamentals, but wary of soaring gasoline prices, several politicians in the US want the government to release petroleum stocks onto the market from the Strategic Petroleum Reserve (SPR). But Michael Levi of the Council on Foreign Relations points out that no-one really knows whether the market would interpret such a move as a bearish or bullish signal. If prices are surging because of worries of unrest spreading to Gulf oil producers such as Saudi Arabia, a release of oil from the SPR might spook traders into thinking the White House knew something serious and immediate was brewing.

There are other possible macroeconomic pitfalls. The European Central Bank is worried about inflation – a main outcome of rising energy costs. But lifting interest rates, as it seems inclined to do, will soften the dollar against the euro (and increase the dollar price of oil) and could be devastating for some of the Eurozone's weaker economies, believe many economists.

It's also a distressing period for the greediest oil consumer of them all, the US. Every extra cent spent on gasoline is a cent not spent elsewhere in the American economy, cutting wider consumer demand. And gasoline is soaring again (averaging $3.55 a gallon on 17 March). Already-weak growth there and elsewhere could grow much weaker. Bank of America has already shaved its global GDP-growth forecast for this year from 4.4% to 4.3%. Real GDP in the US will be just 2.8%, against earlier forecasts of 3.1%.

That leaves all eyes on China, where demand for oil continues to grow rapidly. "Don't think that China's leaders aren't terrified of these prices," says Levi. Inflation worries Beijing, too, although its efforts to control it through monetary policy have yet to bear fruit.

Yet China's demand for oil continues to rise, regardless of the market's direction. Its hefty dollar reserves, rapidly growing economy and large export-import surplus have made it much more immune to oil prices than Western economies. "Globalisation was great for the West until it started paying Chinese prices for oil," says one analyst.

All of this adds up to a worrying outlook for the global economy, even if China, so far seemingly unscathed, continues to grow. If $115/b were to persist through 2011, the IEA says, global GDP for the year could come in at anything between 1.0 and 3.5 percentage points below the IMF's assumed 4.3% rise.

That could be a devastating blow to the parts of the world where economic growth remains anaemic. In the coming months, spending cuts and the end of quantitative easing could combine with persistently high oil prices to make a severe dent in the recovery. Unlike 2008, however, the monetary and fiscal-stimulus responses for these economies no longer exist – those arsenals are depleted. "A double-dip now could be far worse than 2008," says one analyst. "We've blown our load."

Such thoughts should worry oil producers, even as they enjoy the bonanza today. Demand destruction is on its way. But more economic chaos may be coming with it.

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