As we are now seeing an 'echo' of the huge spike in oil prices that in my view precipitated a US recession as much as the implosion of the credit markets, it's worth revisiting the 2008 bubble in energy prices. The historic oil price shock of 2005-8 was triggered not by a supply interruption like that of the 1970's but simply by stagnating supply in the face of soaring demand. This reduced the daily supply cushion to uncomfortably low levels at 1-1.5m b/d (now up to 5m plus), thus magnifying the potential impact of any threatened supply disruption, be it from Nigerian militants or a Gulf Hurricane. The impact on prices was exacerbated by a speculative mania that gripped the poorly regulated and opaque energy markets from late 2007, creating a parabolic blow-off move to the $147 high last July. Crucial to this whole destabilizing episode was the role of Saudi, which was no longer willing to act to regulate prices (production actually fell in 2007) whether through policy (and Crown Prince Abdullah spoke in April 2008 of 'leaving it in the ground for our children') or the much rumoured degradation of their key Ghawar field.
On the demand side, Chinese consumption had been growing at 7% pa for two decades, and was 870k barrels higher in 2007 than 2005 (imports of 3.6m b/d), while over the same period of strong economic growth, daily consumption fell 122k in the US, 346k in Europe and 318k in Japan in response to soaring prices. World GDP grew 4.9% between 2003-7, against 2.9% annually in the 1990's, pushing the equilibrium price for oil sharply higher in the context of stagnant supply and that 'fundamental' price was probably just sub $100. Ultimately, demand elasticity proved higher than the bulls expected, and US consumption began to collapse even before the financial crisis last Autumn; energy as a share of US total consumer spending had risen from sub 5% to 7.5% in three years, effectively a tax increase on already stagnating incomes. Changing fundamentals alone cannot explain the move in crude oil from $92 in December 2007 via $147 in July 2008 and then to $40 by December, although the key driver was undoubtedly the flatlining production at 85m b/d that resulted from two decades of underinvestment.
Recklessly loose Fed monetary policy in early 2008, as now, encouraged the use of oil futures as a purely financial hedging instrument or an 'anti-dollar' play. On July 17th last year I wrote: 'As US energy demand is now slumping (both natural gas and gasoline), Asian demand growth has peaked, and 800k b/d of additional Saudi supply is coming on stream, I'm expecting $100 to be tested by the Autumn...any re-regulation moves to limit index fund buying by the CFTC (and after the SEC moves on bank short selling this week, Washington has finally found religion on taming destabilizing market excess) will speed the slump in energy prices.'
Demand collapsed as I expected, but amazingly nothing has been done to rein in OTC oil trading, which allows for manipulation and market abuse as noted by the investigating Senate committee last year, which castigated the CFTC for its oversight failures.The oil price is now back at levels above $68 seen in late 2006/early 2007 amid a global economic boom , and just before the explosive speculative surge that peaked in Summer 2008. The impact of soaring gas prices on already overleveraged US consumers is generally underestimated, and proved a critical tipping point that accelerated housing foreclosures and a retail spending slump, as discretionary income was squeezed.
In the last month, average US gas prices have jumped over 20% and are now approaching $2.50, despite ongoing demand destruction and ample global stocks of crude and products. Why? At $40 and below, crude was a steal, as that was barely above marginal cash production costs (and marginal costs of new offshore production are about $70). The steep contango structure in the market until recently encouraged not only OPEC quota compliance but also speculative arbitrage between spot and futures by storing oil in offshore tankers.As a result, over 100m barrels is now floating in tankers awaiting a home (at a storage cost of $1/barrel per month), while onshore storage tanks are also full to capacity (including both the Chinese and US strategic reserves). While the 2007/8 bull run was driven fundamentally by a narrowing cushion of daily supply over demand, there is no such constraint for the next couple of years. Essentially, the tidal wave of liquidity unleashed by Fed monetary policy is now washing through the commodity markets directly in driving speculation and rising inflation expectations and indirectly by undermining the dollar.
As I forecast early this year, inflation expectations as reflected in the 10 year Treasury/TIPS spread are already back at 'normal' levels of near 2%, after the deflation panic earlier this year. It is quite possible we will see $70-75 oil by year end, if and only if we see sustained evidence of a global economic recovery in 2010, but the market is getting ahead of itself. Near term, the speculators who bought oil around $40 are looking at a 50% return in a few months after storage costs, and the temptation will be to bank it as the price curve has flattened sharply. That would swiftly reverse much of the current move, particularly in conjunction with a stabilizing dollar. Otherwise, a move above $70 on pure technical momentum at this fragile point for the US economy would prove a major setback to recovery hopes, particularly with mortgage rates heading above 5% again and refinancing activity dropping fast. While equity markets are being boosted overall by the oil surge thus far, that may soon change if it begins to kill some of those tender green shoots, and re-regulation will be belatedly back on the agenda.
