Deflation, reflation and our oil future
The only function of economic forecasting is to make astrology look respectable.
— John Kenneth Galbraith
I suspect that most of those concerned about a peak, plateau and decline in the global oil supply assumed that such events would eventually cause a reeling economy like the one we have now. But something else happened instead—the depression—or something very much like it—came first.
When will a faltering oil supply and high energy prices next have an impact on global economies as they did in 2007 and the first half of 2008? The answer depends entirely on whether the severe global recession lingers—Nouriel Roubini calls it stag-deflation—for some years or starts to ease as early as 2010.
How do these poor economic conditions bear on the oil question? The easy rule-of-thumb goes like this:
When there is positive inflation and the global economy (aggregate demand & output) grows, so does oil consumption. When deflation rules and the global economy shrinks, so does oil consumption.
Figure 1 — Relationship between real GDP and oil demand growth. From my Trouble With Oil Down The Road (taken from the IEA)
I have written a long essay Depression or Recovery—What’s In the Cards? to examine the past, present and possible future state of the economy. That article serves as an essential companion piece to this column. I examine long-term indebtedness in the United States, deflation versus (positive) inflation, where things stand now, and the past, present and future measures being taken by the Federal Government and Federal Reserve to extricate us from the mess.
My analysis attempts to show that the deep roots of the economic crisis result from a 30-year private credit bubble. This situation will not be undone in a few months, a few quarters or even a few years. If you do not agree that our economy is structurally unsound, and that repairing it will take some time, you will probably not accept my view of the timing of renewed problems with the global oil supply.
My basic thesis runs as follows: if the United States and the other OECD countries experience a long (2-3 years) period of deflation, global oil demand will plummet and prices will remain low throughout the downturn. Afterwords, inflation will drive borrowing and spending, so aggregate demand and output will increase during the bounce. Renewed GDP growth will drive up oil demand. Some years into the recovery, and depending on its strength, oil prices will spike as geological and geopolitical constraints on supply once again come to the fore.
The sooner a recovery begins, the lower demand destruction during the recession will be. Oil prices will thus spike sooner as demand once again bumps against the ceiling on supply, a limit that remains invisible until demand bounces back. It’s all a matter of timing. It’s easy to see that in the more dire economic scenarios, it could be many years before global oil supply problems resurface.
This view acknowledges that “decoupling” theory is all but dead. The story was that the BRIC countries (Brazil, Russia, India, China) could continue their economic growth even if the United States went into recession. The situation is more complicated than this simple theory suggested. The Eurozone, China’s largest export customer, is also in recession as are Japan and Korea. The recession is truly global in scope. As a result, growth in China and India is slowing down. Russia’s economy, which depended heavily on oil export revenues, is almost dead in the water. Brazil is trying to avoid a recession. Thus rapid economic growth in the BRIC economies will not support oil demand as it did in past years. Domestic oil demand growth will likely decrease in Saudi Arabia too.
This line of reasoning also suggests that mitigation of the world’s oil dependency from efficiency measures or substitutes (e.g. plug-in hybrids or biofuels in transportation) will be virtually nil during the downturn and the early years of the recovery. A combination of low oil prices that discourage implementation of substitutes along with insufficient time for research, commercial development and significant market penetration of new technologies supports this assumption.
Ka-Poom Theory — An Example
itulip’s Eric Janszen provides a road map called Ka-Poom theory to guide us as we consider our muddled economic future (Figure 2). I am citing it for illustrative purposes only. Although the theory may not be correct in all its details, especially as concerns the duration and severity of the current downturn, it likely broadly reflects what the next decade will look like. There is a period of deflation (or disinflation) like we are in now followed by inflation when the Federal government and the central bank successfully reflate the economy. These issues are discussed at length in my Depression or Recovery essay.
Figure 2 — Ka-Poom Theory from Eric Janszen (itulip.com@2006). Annotated to reflect the current recession (in gray). Note that the start of the current downturn (December, 2007) was predicted in 2006 following the reflation that began in 2003 after the collapse of the stock market (Tech) bubble
Ka-Poom theory is explained in a more recent article—
…the Ka-Poom model explains how, following the collapse of the credit bubble, the US economy will experience a short (six month to one year) period of deflation that we call disinflation, such as we are experiencing today, followed by a major inflation induced by monetary [via the Federal Reserve] and fiscal [via the Federal Government] policy and the actions of US trade partners in response to that inflation.
…The difficult part is forecasting what comes after the disinflation phase. Does the Fed sit back and do nothing while the debt deflation runs out of control? Does the Fed have a choice, or does it become impotent, overwhelmed by the rate of debt defaults and money destruction?
The correct answer to these crucial questions is that the Federal Reserve and the U.S. government will actively try to reflate the economy and positively have the ability to do so—on this point, Janszen and I, not to mention Ben Bernanke, Barack Obama, Larry Summers, Paul Krugman and a host of others, are in complete agreement.
Efforts to reflate the economy began when the Fed started cutting the Fed Funds target interest rate early in 2008 and continue in various ways today (e.g. the TARP, the proposed Obama stimulus plan, the expanded Fed balance sheet) as discussed in my Depression or Recovery article. All these measures have failed up to now, but if at first you don’t succeed, try, try again.
You can see that something very similar to the “Ka-Poom” scenario happened in the 1930s (the green circle in Figure 3).
Figure 3 — A “Ka-Poom” event in the 1930s. Taken from Monetary Policy in a Zero-Interest-Rate Economy (Federal Reserve Bank of Dallas, May, 2003) Annotated (green circle) at itulip.com
A 2nd Great Depression is certainly the worst case scenario, but a repeat of the cascading bank failures that took place in the early 1930s has probably been averted by Fed and government intervention. Still, we need to be careful here. Nouriel Roubini’s analysis indicates that the banking system is effectively insolvent and will likely not survive in anything like its present form without additional rescue packages and guarantees like those given recently to Citigroup ($300 billion) and Bank of America ($118 billion). The situation is unstable, but the caretakers are bound and determined to bail-out the banks and reflate the economy.
The Oil Supply Problem Did Not Just Disappear
This all-too-brief overview of our economic future relates to the “peak oil” issue in a very straightforward way. Oil demand and prices will remain depressed during the deflationary period (2008 Quarter III–?, the “Ka” part of the model) and then rebound as they did in recent years when inflation takes hold again (the “Poom”). In the inflationary period that preceded the current downturn from 2003–2008 Quarter II, oil demand and prices rose steadily against a backdrop of faltering supply after 2005.
The next inflationary period shown in Figure 2, when it finally kicks in, may have very similar effects to the previous one, but this is not guaranteed because we’re in dire straits now. If aggregate demand and output growth in the next period turns out to be robust, which I consider unlikely, the end game may play out very differently this time around, with oil scarcity taking on a much larger role in determining our economic health than it did these last few years after the collapse of the Housing Bubble.
If all of the OECD economies stagnate for a long time, like Japan did in the 1990’s and thereafter, the oil supply problem may be postponed that much longer. Oil production capacity would eventually fall to the level of demand, but who knows how long that might take? There are just too many variables to consider here—future demand levels, future production decline rates, future investment levels and oil prices, OPEC policies going forward, longer term economic growth rates in the BRIC economies, etc. Yogi Berra said it best: “It’s tough to make predictions, especially about the future.”
When the global economy was booming and oil demand was strong, I thought the “peak oil” situation was pretty much cut and dried. Now the waters are muddied. I am reminded of a scene in the great 1970s movie Three Days of the Condor.
In a memorable scene in one of my favorite movies, Three Days of the Condor, the spy thriller in which a low-level CIA researcher (Robert Redford) uncovers a rogue conspiracy inside the CIA, the researcher’s handler (Cliff Robertson) and one of the agency’s deputy directors (John Houseman) share a moment of reminiscing about the history of the intelligence business. Houseman recalls his early experience: “I go back even further than that. Ten years after The Great War, as we used to call it. Before we knew enough to number them.” And Robertson asks: “You miss that kind of action, sir?” To which Houseman replies … “No, I miss that kind of clarity.”
I miss that kind of clarity and I’ll bet Saudi Aramco, Lukoil, Rosneft, PDVSA, Petrobras, the NPD, Shell, BP, the NIOC and Suncor (to name a few) do too.
Recently revised EIA data show that the world crude oil supply fell year-over-year in 2006 and 2007, but started to rise over the average 2005 level in the first half of 2008, peaking in July at 74.885 million barrels per day (b/d). The latest data for September, 2008 is nearly 2 million barrels below the July level and subsequent months will likely shave more barrels off that number. World demand appears to be crashing faster than supply is falling, a deteriorating situation OPEC is trying to reverse. This imbalance has pushed the oil price off a cliff, but can not account for all of that price decrease.
I have argued that it is impossible to separate oil supply issues in the medium-term from the demand destruction caused by a contracting global economy. This view must be weighed against the strong likelihood that the crude oil supply will never again exceed its July, 2008 level. Aggregate demand and output rises & falls, but depletion never sleeps. Even in a depression, oil will still be produced at prodigious rates in struggling countries (e.g. Russia, Venezuela) and in declining countries (e.g. Mexico, Norway, the UK, and the United States). Tar sands oil from Canada will see a dramatic slowdown in the rate of production growth. All the while, cost factors will make it harder and harder to put new oil on-stream.
It is not inconceivable that lack of investment and low oil prices during a prolonged depression will do irreparable harm to the oil & gas industry outside of the Persian Gulf in a world where marginal production costs for new oil (e.g. in the Brazilian ultra-deepwater) are very high indeed. A distressed oil industry will have even more difficulty raising production to meet renewed demand than it would have under normal economic circumstances.
I will defend my view that world oil production peaked in July, 2008 in next week’s column. For now, our desperate economic situation probably entails that no one will notice that we’re past peak for many years to come. It is an absurd but dangerous situation which lies down the road. Just when you’ve solved one disaster, you’ve got another one. Welcome to the 21st century.
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