Tuesday, December 8, 2009

The Second Shock: Agenda for the Next Few Weeks

This morning, I want to briefly lay out what the issues are that I want to work on via this blog. Obviously, surprises might turn up, but certain things I can see clearly are going to need to get covered, and I'd like to try and summarize that agenda.

What I think is going to happen in the world is roughly as follows: currently, and for another year or N, OPEC has some spare capacity, and will most likely act to moderate prices somewhat - they will go roughly sideways for a while (give or take a few $10s/barrel). However, as the global economy slowly recovers from the 2008-2009 recession, eventually that spare capacity is going to get eroded, and we are going to get a second price spike, probably bigger than the one in 2008, and big enough to get everyone to really take the oil supply situation seriously and put us on the kind of efficiency trajectory that is actually needed. That second shock will also trigger another recession.

I'm not alone in this view, of course. I was recently catching up on Robert Rapier's blog, and he expresses a similar opinion:

One of the themes I have been hitting during my recent presentations concerns the oil price risk hanging over our heads. My hypothesis goes something like this. The days of huge supply excesses in the oil production world are over. Those 5 million barrel per day supply cushions of 10 years ago kept oil prices low, and fairly stable. As the excesses shrank we began to see increasing volatility and prices steadily climbing. Higher oil prices have historically caused recessions. We are currently in a recession, albeit one in which high oil prices weren't the primary cause. (More on that at the end).

But, oil supplies were already tight prior to the recession. The recession has lowered demand, and at the moment we find that we again have a fair excess of oil production capacity. As global economies strengthen, that increases the demand for oil. One of the things I have been pointing out in my presentations is that U.S. oil demand dropped by 1.2 million bpd over the past four years, but demand in India and China increased by 1.9 million bpd over that time period.

Therefore, it won't take long for the capacity cushion to shrink and for oil prices to spike up again, putting us back at risk for recession.

What I want to do is try to put bounds on the timing, size, and impact of the second shock. That requires us to explore a variety of factors:

1) The ongoing growth of developing country demand - this is probably one of the more predictable elements of the situation - the extra million barrels/day each year of demand will probably go on fairly inexorably for quite some time, with perhaps a wildcard possibility of some kind of political or economic upheaval in China or the Middle East.

2) The dynamics of the recovery. This graph from Calculated Risk summarizes the US employment situation:

It very much looks like we are reaching the bottom of the job losses, and will now start the slow climb back up over the next couple of years. So we need to translate that into oil demand, and explore the variations on this theme in the rest of the OECD.

3) How much spare capacity does OPEC really have? Obviously, this is mainly an update on the old questions about Saudi Arabia. Do we assume they can get back just up to about the historically demonstrated 9.5mbd? Or is it reasonable to believe recent megaprojects have increased capacity more than production in the supergiant legacy fields will have declined in the interim?

4) Iraq is a major wildcard. The Iraqi's have recently been signing a bunch of deals to develop and redevelop their reserves and greatly boost production. There's little question they can produce significantly more than they have been, but how much, and how fast? Is there any plausible scenario in which global demand can grow slowly enough that the Iraqi cavalry arrive before the rest of the world's oil producers scalp the unwilling oil consumers?

When the shock does come, how big will it be? I think we can guess the order of magnitude: in the range of hundreds of dollars per barrel. But can we constrain any more tightly than that what is required to set the world on the necessary path of sustained improvements in oil efficiency?

And then what are the implications? I haven't blogged about it yet, but I've been updating my biofuel production spreadsheets and those ethanol producers have been ramping things up again, even before another price spike. This is mainly a question of the policy environment - will the fuel-food arbitrage be allowed to run it's free-market course, or will policy-makers intervene with enough force to stop it? If it does run it's course, what are the impacts, who are the winners and losers - I am realizing this is a very complex question. On the one hand, the poor and the hungry are in developing countries, and would appear to be most vulnerable. On the other hand, developing countries are mainly agricultural producers and stand to benefit from higher farm prices.

So those are the things I'm going to be working on...


Datamunger said...

My guess for the next decade is that no raw measures of US individual and household economic well-being will exceed their old highs.

But most people may not really suffer that much because tech will continue to deliver the goods. Yes, bread is expensive but circuses are better and cheaper than ever. (iPod Touch with 64 gig of ram!). We don't really inhabit the planet as it is and never have...our being is mostly elsewhere. It's not a bug, it's feature! The PTB just have to be smart enough not to abuse it.

Datamunger said...

That was the upside... the downside is depression. Can't be ruled out.

I agree with Meredith Whitney that they are running out of bullets. But they still have a few. If we were sitting here with 10% inflation and gold at $3000, then the ammo's truly gone and even Krugman will have to admit there were deep structural problems behind a lot of this.