May 9, 2004

The Good Book knows that oil and economies don't mix

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The Pharaoh woke 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. Oil is now touching $40 a barrel and the question is whether this is just part of the cycle or something more serious.

With rising oil prices dominating both headlines and bottom lines, the question is who is right – the orderly prophesies of Joseph in Genesis or the apocalyptic ones of John in Revelation?

Let us take the biblical view and examine the long-term trends and dynamics of the industry. 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 $20-30 a barrel range.

Following the Iraqi invasion of Kuwait, prices spiked 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 both Gulf wars was more important for the future price of oil. When the global price of oil is $20-30 a barrel, a significant number of wells will come on stream that would not otherwise be profitable.

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.

However, the immense cost of oil drilling in the Russian Arctic or the depths of the North Sea means it might only make commercial sense to produce oil in these inhospitable conditions if the price is above about $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, as it is now, 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 and we may be on the cusp of it again. In 1993, too much oil – without commensurate demand in Japan and Europe – caused prices to fall until eventually it dropped below $10 in 1997/98.

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 known as `Moms and Pops’) began to shut down. Typically, these tiny wells (hundreds of which exist all across the US) are run by families and supply 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. As Joseph could have told us, without supply we run down stocks and without stocks there’s no buffer if shortages occur.

The seven-year cycle has run its course – since 1997, oil has gone from$10 a barrel to $40 - and the world finds itself with very little stocks, high and rising demand from the US, a resurgent south-east Asia and Europe, not to mention political problems in the Middle East (However, economics not politics determine the price of energy in the long run because the sellers, no matter what their disposition, have to sell the stuff).

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

This is a godsend to expensive producers like Russia. It has allowed Russia’s economy to recover dramatically on the back of higher oil prices, which has financed Vladimir Putin’s war in Chechnya, as well as paying Damien Duff’s wages.

Amazingly for the US – which was accused of waging a war in Iraq for oil – prices are over 25 per cent higher than when Baghdad fell last year.

In addition, the boom in China continues to underpin global demand. All Chinese oil is imported. However, as production cranks up to avail of the new higher prices and business plans factor in the barrel price, supply will increase dramatically in the years ahead.

But will prices go higher? Despite all the talk this week in financial markets of a new economic boom and rising interest rates, the world has never grown robustly with oil at $40. 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 many things, from road haulage to Ryanair flights (despite the present price war). It also takes money out of our pockets and gives it to oil producers.

When energy prices are low, the money saved either goes into more profits or more wages for everyone. 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.

So prices should fall quite soon. But what about the more serious issue of the world running out of oil. What if we are seeing the beginning of the end? In a new book called The End of Oil, author Paul Roberts argues convincingly that we have burned our way through at least half the available oil in the world.

He claims that production will peak in the next ten years and we are facing a half-century where it will become apparent that the world is running out of `black gold’.

This means that every new trough will be at a higher price and every new peak will be similarly higher. The lifestyle implications of this for Ireland are very significant. Our way of life, as we know it, is based on oil being plentiful and affordable.

Practically speaking, oil is as essential to us as air and water. In addition, recent research by consultancy firm Amarach revealed that the Irish are oil junkies.

Ireland uses more oil per head than almost anywhere in the developed world. Instead of preparing ourselves for any long-term oil problem, we are behaving as if the stuff will gush out of the ground indefinitely.

So will the oil market follow the logic of the very first book of the Old Testament or the very last book of the New Testament? In Genesis, Joseph’s prophecy of orderly seven-year cycles has characterised the market for the past 50 years.

If this continues we have little to worry about. On the other hand, in John’s Book of Revelations, the Apocalypse reveals itself as a series of natural upheavals and none would be more disastrous and fitting for modern society than the world running out of oil.

Who said economics was the new religion? The big questions it seems are still firmly rooted in the scriptures.