Oil market is talking itself into demand destruction
The oil market is talking itself into another bout of demand destruction
TAKE a forecast for global economic growth and punch it into your calculator. Then take your pencil and draw a line starting at the bottom left of your page and ending somewhere near the top right-hand corner. See how easy it is to predict crude prices?
That's about the shape of the game being played by Wall Street's investment firms, says Stephen Schork, an influential market commentator and editor of the Schork Report newsletter. Few forecasts account for another bout of demand destruction, he says, the inevitable outcome of spiking oil prices. "A bunch of equity guys looking into the commodity market," is how he describes the horde of analysts now predicting more inflation in oil markets.
It's not an entirely fair picture – even after the cull of recent years many bright minds have survived in the West's financial-services sector. But the reports from the banks are starting to build their own potency. Goldman Sachs, which led the herd of bulls as prices soared in 2008, is at it again. The bank, which also takes a position in the oil market, says crude prices will average $100 a barrel this year and $110/b in 2012. Morgan Stanley's forecast for 2011 is the same. Deutsche Bank, a more moderate forecaster, reckons oil will average $87.50/b, an upwards revision from a previous prediction. And so on.
Here come the speculators
All of this is drawing investors (less neutrally known as speculators) to the funds and firms that now trade oil as if it weren't something to be refined and turned into fuel. And such is the market's sentiment that the financial bust and commodity bubble of 2008 seem distant memories. Even a recent softening in prices, with New York's March light-crude futures contract easing by a couple of dollars to just over $88.00/b on 24 January, is being treated as a mere blip on the way to new highs. And while WTI's price is being held down by new US imports of heavier crudes, especially from Canada, Brent continues to soar, buoyed by outages in the North Sea. In London it was trading at around $97.70/b as Petroleum Economist went to press – a premium that defies its historical discount to WTI.
The solution to high prices, runs the old adage, is high prices. So if oil markets continue to surge, as many analysts expect, one outcome is likely: people will stop buying as much of it. Another is also possible, and more worrying: a denting of the global economic recovery.
In the US, which for all its problems remains the world's biggest oil consumer, oil above $100/b translates into gasoline prices of about $3.30 a gallon (USG), says Schork. That such fuel prices would still be low compared with levels in other countries is irrelevant: every extra cent spent on gasoline is money that isn't being spent elsewhere in the US economy. US consumers are now directing about 3.5% of their outlay to energy – still shy of the 4.5% seen in the first half of 2008, but well above long-term historical norms.
And the risks of high oil prices are being felt everywhere else, too. In the UK, fuel prices are soaring, thanks to costly feedstock (oil), a weak pound and rises in taxation. Gasoline and diesel are averaging £1.28 a litre ($1.84/l, or $6.98/USG) and £1.33/l, respectively, the Automobile Association (AA) said last month. Indeed, the AA reckons UK consumers are spending about £10m a day more on fuel than they were a year ago – another big chunk of cash not being spent elsewhere in a weak UK economy.
These are grounds for more demand destruction in the West – and for more economic pain. Fatih Birol, the International Energy Agency's chief economist, said last month that oil prices had entered a "dangerous zone" for the world's economy. Oil-import bills had soared, he pointed out: the OECD's annual spending on imports alone had risen by $200bn, to $0.79 trillion, by the end of December. That's a total not far off the amount spent in the US stimulus package after the economic meltdown took hold in 2008. And, says Birol, it's equivalent to about 0.5% of the OECD's GDP.
As if anyone needed reminding, things are getting perilously similar to the boom-bust year of 2008, argued Birol. Then, for example, EU members were spending an unprecedented 2.2% of their GDP on oil. If oil prices remain above $90/b this year, the figure will be 2.1%.
Birol reckons producers should push more oil onto the market, or risk seeing customers suffer. Yet the biggest difference between now and 2008 is that oil supplies, at least theoretical ones, are ample. US stocks, which rose by 2.6m barrels to 335.7m barrels for the week ending 14 January, remain within historical norms and far higher than in 2008, although the halt of drilling in the Gulf has offset this, to some extent. New production from Canada, Brazil and other non-Opec nations is rising. And Opec's spare capacity is close to 6m b/d, although this matters to market sentiment only if the group is prepared to use it. It ought to, or risk copping the blame again for high prices, as it did in 2008.
So a supply crunch isn't propping up the market. A wave of cash released by the US Federal Reserve's second round of quantitative easing is a more likely support. But demand, and especially forecasts for ever greater Chinese consumption, remains the biggest encouragement for the bulls.
This is foolish. A weaker global economy will want less oil. And even in energy-hungry China, rising fuel prices are now a worry. On a purchasing-power parity, Chinese consumers are paying as much as, or sometimes more for their fuel than Americans, says Peter Tertzakian, chief economist at Arc Financial, an investment bank. Inflation has become a big worry. Twice in the last two months of 2010 the Chinese government lifted interest rates to keep a lid on rising prices. It might do so again, soon.
If the trend continues, China's growth will cool and so will oil markets. Whether that happens before yet more structural demand for oil is destroyed in the West is questionable. But this is no time for anyone who likes healthy economies to be willing the market higher – or for producers to be rejoicing.
Stagflation – inflation alongside high unemployment – would be as disastrous for consumers in the West as for oil producers. Few of them predicted the crash of 2008. That no one expects another collapse in oil prices in 2011 isn't reason to think it can't happen.