Friday, July 31, 2009

Barrels and Big Macs

Dealing with sudden inflows of oil revenue would at first glance seem like a problem any nation would gladly welcome.

However, if oil accounts for an unusually large share of a nation's total exports it can result in the currency of that nation rising too rapidly for non-oil parts of the economy to adjust. The problem is exacerbated by the cost of labor and real estate in that country surging. The currency strengthens and costs become high because of the constant and rapid flow of US dollars in and physical oil, rather than the nations currency, flowing out.

Strong currencies and high costs make it difficult for non-oil exporting industries in a nation to compete internationally.

Oil exporting nations end up with an oil industry and little else. When oil production eventually declines, or oil prices fall, the nation has nothing to fall back on. This is known as Dutch disease and is described further in Oil 101.

The solution to Dutch disease is to try to keep oil revenues invested overseas and to bring it back only when the nation's oil industry begins to wane. This is, of course, extremely challenging to implement. People want money to be spent now and politicians know that one of the surest (but often most reckless) ways to stay in power is to spend money now.

The oil exporting country which is held up as the epitome of avoiding Dutch disease is Norway. Norway is the third largest oil exporter in the world behind Saudi Arabia and Russia. Norway has a very large petroleum fund which keeps revenue invested overseas. Despite this, Norway is an expensive country to live in.

The Economist magazine, which coincidentally coined the term"Dutch disease" in the 1970s, produces a survey of the cost of a McDonald's Big Mac hamburger in various countries across the world. The survey is both a serious and light-hearted method of determining the relative costs of living.

The latest Economist Big Mac Index survey just published shows that a Big Mac in Norway is the most expensive in the world at US$6.15, which is 72% above the same hamburger in the US (US$3.57). Other oil exporting nations didn't fare as badly and most are surprisingly less expensive than the US:

Undervalued vs. the US (local Big Mac price in US$)
Malaysia -47% ($1.88)
Russia -43% ($2.04)
Mexico -33% ($2.39)
UAE -24% ($2.72)
Saudi Arabia -18% ($2.93)
Canada -6% ($3.35)

Overvalued vs. the US
Brazil +13% ($4.02)
Norway +72% ($6.15)

One might think that the high cost of Big Macs in Norway is a recent phenomenon following the run up in oil prices during 2008. However, looking at the following chart of the Big Mac index over the past four years, it shows the persistence by which costs in Norway have remained high.

(source: Bloomberg chart of Economist Big Mac Index - click to enlarge)

Other methods of calculating relative costs, such as those carried out by the OECD, show costs in Norway to be 24% (source: OECD data from Bloomberg) above that of the US. So when a more rigorous and comprehensive analysis is performed the cost disadvantage of Norway may not be as dire as the Big Mac index suggests - but the symptoms of Dutch disease still persist.

The US$325billion (approx. US$70,000 per citizen) Norwegian offshore petroleum fund is large, but perhaps still not large enough to cure Dutch disease.

Oil Price Boundaries

I discussed the rally up toward US$70 per barrel with the Wall Street Journal:
But higher oil prices could prove the oil rally's undoing, said Morgan Downey....Rising crude futures will eventually translate into higher retail petrol prices, which would force consumers to spend more on fuel and less on other goods that might spur growth in the wider economy. "The increase in oil prices has a real impact on consumers wallets. It's money that is not going to be spent on purchases," Mr Downey said. (source: WSJ)

Wednesday, July 29, 2009

Blaming Oil Speculators = "I Don't Know"

The US government has on occasion during several administrations acted irrationally and in anger trying to manage oil prices with disastrous effect on the US economy. As explained in Oil 101, lines at the gas pump in the US during the 1970s were created by the government. If the government did nothing then oil prices would have been higher, but there would have been no shortages at US pumps.

Today we are facing a seismic fundamental shift in the physical oil market. A similar shift has never occurred in the 150 year history of the modern oil industry. When prices become more volatile and there is a lack of understanding of the fundamentals, a visceral reaction is to look for scapegoats to blame. The current scapegoats are speculators.

Blaming volatility on speculators is a face saving way of admitting that the blamer has no idea what is going on in physical oil markets. Physical oil supply and demand explain EVERY price move in oil. As mentioned previously, blaming speculators is not simply wrong, it is dangerous. It is dangerous because it falsely diagnoses the challenges global oil supply is facing.

There is absolutely no need to change US oil markets. Yet such change now seems likely. Politics is about to raise oil prices in the US and lower them for the rest of the world.

My estimate is that certain proposed restrictions in the US will add between 25 to 50 cents per gallon onto US pump prices in the short term (1-2 years) and much more later. US price increases will subsidize price falls in other countries. This is going to hurt US business and consumers to the advantage of other nations. Each US household will transfer up to an additional US$2,000 overseas each year. A woeful vengeance is being extracted by the uninformed. Preventing such a situation was the reason for writing Oil 101.

I was quoted by The Associated Press yesterday:
"If you start to restrict the market, it's hard to see what that achieves," said Morgan Downey..."People don't like to see the prices, but the market is working fine."

Sunday, July 26, 2009

Tale of the Curves

(click to enlarge - data is NYMEX WTI Crude forward curves)

OPEC members play a market balancing act. They want prices to be as high as consumers can bear, but no more. OPEC do not want oil prices to move so high that consumers stop buying and the oil begins to fill storage tanks.

After flattening as oil prices recovered from just above US$30 per barrel at the beginning of 2009, crude oil forward curves have been steepening (contango has become more pronounced) over the past three weeks on oil reaching over US$70 per barrel.

Increasing contango is often a bearish oil price signal as it shows storage owners are seeing more demand for oil to be stored rather than consumed.

We may finally have reached a price point (just above $70) in the 2009 supply driven rally where OPEC's supply cuts have caused prices to rally to a level at which demand wanes.

This is a genuine economic recovery. However, it is a fragile glass-like economic recovery, ready to shatter at any moment. OPEC now have to tread more carefully to ensure that oil prices are not the stone which breaks it.

Sunday, July 19, 2009

The 4% Rule: Oil above US$80 Equals Recession

(WTI Crude at the time of writing is US$64/barrel)
Oil above US$80 per barrel puts the world into an economic death zone.  As was evidenced in 2008, brief spikes above US$80 per barrel are possible but not for more than 6 months.  Historically, the longer oil prices stayed above the economic death zone level the more severe the following recession.

Oil consumption grows predictably when oil spending is below 4% of GDP. For developing nations, oil demand grows as a function of income (measured by GDP) and population. For developed nations oil per capita consumption tends to be relatively stable and oil demand grows with population.

An observation made in Oil 101 (pages 15-16) is that when spending on crude oil has risen above 4% of GDP, global oil demand has fallen. Such global oil demand destruction occurred in 1973-1974, the early 1980s, the early 1990s and in 2008.

(source: page 17, Fig. 1-10, Morgan Downey, 2009, Oil 101)

(source: page 17, Fig. 1-10, Morgan Downey, 2009, Oil 101)

The crude oil price equating to spending 4% of GDP is shown on the following chart along with historical realized prices. As you can see, in 2009 the oil price which equates to 4% of GDP is US$80 per barrel. Anything above US$80 per barrel may reduce global oil demand and prolong the current recession.
Looking to the future, what if supply declines? How much could oil prices increase? If we hold income (GDP) constant and oil consumption efficiency constant (roughly 4.6 barrels per person globally at the moment) then we get the following chart:

The bottom of the recession zone is the oil price equivalent to 4% of GDP and the top of the recession zone is the price equivalent to 8% of GDP (top of demand destroying price spikes historically). 

[Note that if the purchasing power of the US dollar declines in general against all hard assets and not just oil, then, all other things being equal, oil prices equating to 4% of GDP may increase above the levels shown.]

Wednesday, July 15, 2009

Oil Market Stuck in a Rut

The oil price rally stalled at the beginning of July in the low US$70s. Oil has since retreated down in the high $50s and low $60s, where it is regrouping in anticipation of an increased pace of global inventory destocking later in the summer. My models (I use floating storage as a leading indicator) are not showing the inventory situation tightening yet....but if its any consolation to oil bulls, global inventories appear to have stopped increasing.

The weekly US oil inventory numbers which come out each Tuesday evening and Wednesday morning were not really a surprise. Oil ticked higher today more due to an improved economic (and equity market) outlook rather than any singular oil data point. The Wall Street Journal quoted my scepticism that today's price rally of around $2 up to $61.54 was due to the weekly US inventory numbers:
"There's no demand number that you can point to ... it's just that (distillate) inventories didn't build as much as expected."
Note that in the quote I was referring to today's (Wednesday's) price action and not anything more long term. To put the long term in perspective, here is a chart of oil prices (NYMEX WTI crude) since 2001:

(click chart to enlarge)

Tuesday, July 7, 2009

Oil Demand over Time and Income

In the first chapter of Oil 101, figure 1-13 illustrates how oil demand per capita in an individual country initially evolves due to income changes until income reaches a European or North American level. Once per capita oil consumption reaches 1980 European or North American levels it ceases growing with income.

Page 18, Fig. 1-13, Morgan Downey, 2009, Oil 101

The chart below displays the same data as in Oil 101 but additionally shows the evolution over time. The question for oil forecasting is whether there is enough oil for China, India and other nations in the lower left corner to reach even European levels of oil consumption as their income grows.

(Notes for animated chart above: Vertical axis is annual income per capita. Horizontal axis is barrels of oil consumed per capita per year. The sizes of the circles are related to each nation's relative oil consumption. The chart may be more clear if expanded to your full screen size.)

The chart below is another variation on the same theme, allowing individual countries to be tracked (click on the relevant circle) as well as allowing the scale to be changed from linear to logarithmic. You can click on almost everything in this chart to change the view. Click on the 'Play' button to start the animation.

If you are having problems viewing the above chart or would like to open it in a separate window then click here.
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