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The Peak Oil Crisis: $75 a Barrel

Last week Saudi oil minister Ali al-Naimi revealed the secret for economic recovery, everlasting happiness and you-name-it. The secret -- keep oil prices at $75 a barrel -- turned out to be so simple it is surprising we didn't think of it ourselves.

During the last two years when oil prices took an unprecedented trip from $50 a barrel up to $147, down to $35 and back up to $70, we all learned a lot about how prices affect the world economy. This of course is the message the Saudi's are trying to convey.

The first lesson is that if oil gets too high (as in above $100, or possibly $80 a barrel) the global economy comes unstuck in short order. We lost a substantial part of the automobile industry, nearly lost the airline and trucking industries, and the financial markets promptly entered a death spiral that was only slowed by spending, loaning, and giving away many trillions of government dollars. The take away is that very high oil prices are a bad thing, even for oil exporters.

Six months after oil prices peaked, we were looking at prices down in the $30's. A big drop in demand, much overproduction, and a touch of speculation were behind the big drop. Seven or eight years ago, $30 oil would have been considered high. Now it is disastrous.

From the oil exporters' point of view, a 75 percent drop in income is a major problem, but most observers are rapidly catching on the idea that it will take $100s of billions worth of new investment each year simply to keep the oil flowing at something approaching current rates. Cut this investment very much and a couple of years down the road oil supplies are going to start running short, prices are going to take a serious jump, and the 1930's will start looking like the good old days.

Thus, the idea of a "sweet spot" for oil prices was born. If prices go much higher or lower you have a disaster. Stay right in the sweet spot, $60-80 a barrel, and all will be well --- at least for a while. There are too many forces at work in the world today to expect that a stable trading range for oil can be maintained.

As enthusiasm for an imminent economic recovery in the OECD nations starts to wane, many embraced the idea that the Chinese, even with markedly lower exports, could just keep on growing and growing at 8 to 10 percent each year by building infrastructure and selling stuff to each other. Maybe they can and maybe they can't; the returns just aren't in on this one as yet. If China, however, can keep growing at anything approaching its accustomed pace, Beijing's demand for more and more oil would soon upset any sweet spot. Conversely a drop in Chinese economic activity would likely lead to lower oil prices and less investment.

In recent weeks there has been a stream of stories about the billions of barrels of new oil that is being found, mostly from deep under the seas. Lost in the exuberance is the concept that this is almost all very expensive oil to exploit. With the exception of Iraqi oil, which likely will have its own set of problems, $75 barrel may or may not be enough to bring increasing quantities of deep water oil to the surface. While it is going to take 10, 12, or 15 years before this oil comes into production, decisions about committing capital to the development of these deepwater fields will have to be taken soon if we expect to see production any where close to todays levels ten years from now.

Last week the government revealed that the model it uses to calculate unemployment has broken down due to the severity of the economic decline and has been seriously underestimating the true employment situation in the US. Major revisions stemming from comparison of employment surveys to tax receipts are in the works. Some outside observers are calculating that real unemployment may be more than double the headline 9.8 percent. If this is the case, we should see the results of higher than anticipated unemployment shortly, for the unemployed pay few taxes, sharply reduce discretionary purchases, and eventually default on debt.

Another factor that will erode the status quo is the government's willingness to continue bailing out the economy through a combination of borrowing and printing money. Several important stimulus packages are due to close out in the next few weeks. While there are many proposals floating around Congress to extend or even increase federal support for the economy, sentiment seems to be coalescing around the idea that massive deficit spending has to come to an end.

While the several existing stimulus packages still have many months to run, it would seem that the era of trillions in new government support are over. If this also turns out to be the case, then it is likely that a combination of greater than anticipated unemployment and reduced government spending on the economy will result in a renewed economic downturn in the next few months.

The other major unknown is the course of efforts to curb emissions. By definition these will involve some sort of tax, reduction in subsidies, or cap on the consumption of fossil fuel - possibly on a worldwide basis if an agreement can be reached in Copenhagen this December.

Taken together, all this suggests that keeping the price of oil in the Saudi's sweet spot where it neither creates economic damage nor stints investment is going to be difficult. There are simply too many forces at work for this to be realistic.

What do you think? Leave a comment below.

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