September 10, 2000

Look to the Bible to learn the secrets of the cycles

Posted in International Economy ·
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Genesis offers us a lesson in economic theory that we should apply to oil.

The Pharaoh awoke in a cold sweat. He dreamt that seven healthy cows were devoured by seven famished beasts and seven full, ripe ears of corn were overgrown and strangled by seven limp, diseased stalks. None of his Egyptian high priests could interpret the vision. Finally, the Hebrew Joseph explained that the Pharaoh’s nightmares forecast “seven years of great plenty throughout all the land of Egypt … and … after them seven years of famine … and the famine shall consume the land.” And so it came to pass.

Seven bumper harvests were followed by seven years of global famine. However, because of Joseph’s prophesy, the Egyptians stocked up in the good years and had more than enough supplies to survive the famine while their neighbours starved.

Genesis offers us a first lesson in economic theory, involving forecasting, business cycles, supply and demand, stock building, inventory management and rationing.

A cursory glance at developments in today’s oil market reveals that there is a compelling argument for the reintroduction of compulsory scripture classes in every secondary, not to mention, business school. With rising oil prices dominating both headlines and bottom lines, the almost Biblical seven-year cycles that operate in the global oil market raise the question, where is the modern-day Joseph?

The recent history of oil appears to be one of pretty predictable cycles. In 1990, following seven years of strong global growth, oil prices traded in the $20 to $30 a barrel range. Following the Iraqi invasion of Kuwait prices spiked up suddenly, driven largely by speculators. However, as it was clear that Saudi Arabia would pump out as much oil as necessary to ensure the US won the subsequent Gulf War, prices stabilised quickly.

Arguably, the period preceding the war was more important for the future price of oil. When the global price of oil is between $20 and $30 a barrel, a significant number of wells will come on stream that would not be profitable otherwise. This is because the cost of extracting oil varies phenomenally across the globe.

In the desert, where the oil is gurgling just below the surface, it might be possible to drill, extract and still make a profit at $6 a barrel. Now consider the immense cost of oil drilling in the Russian Arctic or the depths of the North Sea. It might only make commercial sense to produce oil in these inhospitable conditions if the price is above, say, $15 a barrel.

Thus, when global economic demand is strong and oil makes over $20 a barrel, a significant new supply comes on stream as expensive drilling sites become profitable. This floods the market and causes the price to fall. The reason the oil price can be so volatile is that the supply response is slow (as it might take years for the oil to come on-stream) but the demand is quite sensitive.

Therefore, when oil is expensive, its impact on the western economy is so significant that demand can actually fall very quickly. So, by the time all the new oil is drilled, extracted, shipped and ready to be used there might be no buyers and the price plummets.

This process occurred in the 1990s. In 1993, too much oil — without commensurate demand in Japan and Europe — caused prices to fall and eventually, in 1997/98, to trough below $10. This was welcomed in the west, yet as night follows day, the laws of supply and demand were beginning to take effect in the volatile oil market. With prices so low, many large expensive operations stopped producing.

Meanwhile, in the US, so-called “stripper-wells” (also know as “Moms and Pops”) began to shut down. Typically, these tiny wells (hundreds of which exist all across the US) are family run affairs, supplying tiny quantities of oil from the backyard for the family and a bit extra for sale. When prices fall, especially in an environment of full-employment and unprecedented wealth, many people just don’t bother maintaining their equipment and after a few years the “stripper-wells” seize up.

Both of these phenomena — the large-scale and the small-scale response — add up to a massive contraction in global oil supply when prices are weak. And as Joseph could have told us, without supply, we run down stocks and without stocks there’s no buffer if shortages occur.

Now that the seven year cycle has run its course, the world finds itself with very little stocks, high and rising demand from the US, a resurgent South East Asia and Europe.

Because so much capacity was run down during the lean years, there aren’t the resources to respond quickly and prices have sky-rocketed.

Some question the will of the large Arab Opec members to bring prices down. Many argue that the politics of oil are still linked to the Middle Eastern problem. This summer, when the Clinton administration tried to get Yasser Arafat to relinquish his total claim on Jerusalem, the Arab world backed Arafat when he walked away from the table. It is now argued that the Arabs’ refusal to increase oil supply is their way of applying gentle but unmistakable pressure on the US to twist Israel’s arm.

For whatever reason, we now have an economic problem and unlike the biblical Egyptians, we didn’t concern ourselves with old fashioned concepts such as business cycle, preferring instead to eulogise about new paradigms and new economies.

Rising oil prices should best be regarded as a global tax increase in the west, with similar consequences. Expensive petrol pushes up the cost of so many things, from road haulage to Ryanair flights. It also takes money out of our pockets and gives it to oil producers.

When energy prices were low, the money saved either went into more profits or more wages for everyone. Now as the proportion spent on energy rises, there is less left to go around and it is like taking money from us and giving it to oil producers. With less cash, we spend less and demand contracts. This combination of falling demand and rising prices was called stagflation in the 1970s and although we are far from that now, pretending that the oil price increase is of no consequence appears naive.

It is clear that this quite startling increase in energy prices will have a detrimental impact on our economy and our inflation rate. And furthermore, could it possibly be the external shock that those of us banished to “the home for bewildered screeching Cassandras” have been warning about? Maybe not.

Suffice to say that any agnostic reading the Bible would have to agree with Joseph and the Pharaoh. When you are told that things work in cycles and that seven years of plenty could be followed by seven years of famine, the best approach is to be prepared.

See what happens when you forget your religion!