The Confusing Big Picture in the Oil Market

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Oh la la, dear reader…the vigilantes are back!

Those happy trends of the Great Moderation period – roughly, the 15 years before 2007 – have turned for the worse.

Globalization, for example, helped keep prices down in the United States. Americans could reach for all the imports they wanted without getting rapped on the knuckles by the usual consumer price inflation. That is, like a drunk who never gets a hangover, they could enjoy an inflationary boom without ever having to pay higher consumer prices.

Now, the screw has turned a full 180 degrees…now they can cut back…spend less…and still have to pay higher prices! The world was such a benign, forgiving place before 2007. Now it has turned wicked.

Let’s begin our exploration of this nasty turn of events by looking at the oil market.

We are out of oil; at $130, we regard it as too speculative. But that doesn’t mean that the oil bubble is going to burst anytime soon…or that the real price of oil won’t be even higher 10 years from now than it is today.

The Big Picture in the oil market is one of the most confusing and complex we have ever seen. It is like a painting by Hieronymus Bosch, where there is so much going on you can’t quite tell what it all means.

On the one hand, there is the background of supply and demand. Even here, the picture is not a clear one. Oil supplies seem to be running out. Of the world’s 60 top oil producers, 54 report declining output. Indonesia announced yesterday that its production had slipped so much, it was no longer an exporter; the country had to withdraw from OPEC, since it has become an oil importer.

On the other hand, Brazil has recently reported huge new finds. New technologies offer ways to get more oil out of existing fields. And more and more alternatives to petroleum are being developed. Brazil is also the world’s leading producer of biofuels, mostly from sugar cane, and is ramping up production as fast as it can. Solar power is hot.

As for oil itself, there is only so much available…and many experts believe the maximum annual extraction level – Peak Oil – is coming up soon. From that point onward, the world will just have to make do with tighter supplies and higher prices.

Looking at the demand side, we see the opposite picture – a curve rising from here to eternity. A few years ago, millions…maybe billions…of the world’s people lived almost without fossil fuel of any sort. They tilled rice paddies, for example, with water buffalo, cooked their meals on a wood fire, and traveled on bicycles. Now they’re moving to the city, living in apartments heated by oil, eating commercial food grown with plenty of petroleum-based inputs, working in heated, energy-absorbing factories, riding on automobiles and buses, and buying things that take energy to make and energy (usually oil) to deliver.

It used to be a sure thing that if the United States had a recession, oil consumption – and energy prices – would go down. But in the last year, oil consumption in the United States has gone down 1.3% – even as the price of it soared. How is that possible? It is partly explained by that giant sucking sound coming from the emerging markets, the BRICs (Brazil, Russia, India and China) and the Middle East. These countries are all using a lot more energy – partly because they are getting a lot richer, and partly because they tend to keep internal energy prices low (which helps explain why they are growing so fast). Both China and India have refused to allow their large oil companies to raise domestic prices in line with world market prices, encouraging greater consumption. In the BRIC nations, oil use went up 4% during the last 12 months.

But how come investors didn’t see it coming? A man of 30 may be unprepared to die in a train wreck; but a man of 90 typically has a Last Will & Testament. These trends in demand and supply are well known…and they happen slowly. How could investors miss them? How come the price of oil stayed so low for so long? How come it more than doubled since the beginning of ’07…and went up more in the last 6 months than the entire oil price prior to 2005?

*** Let’s look again at this remarkable tableau of the oil market. In addition to the supply and demand pictures, there is a lot more going on. Over on the side are the central bankers – led by Ben Bernanke and the U.S. Fed. What are they doing? Let us look hard…oh yes, they seem to be printing money! Yes, the Fed – the guardian of America’s financial integrity – is lending money at 2% below the official inflation rate (probably more like 6% below the real inflation rate). And it is permitting the supply of money to increase at an estimated 16% annual rate. Remember, when the supply of money increases faster than the supply of goods and services (GDP), prices rise. With GDP flat or barely rising at all, a 16% increase in money supply represents a huge inflationary push.

And look! Prices are rising, just as they should. Want proof? Just drive to a filling station…or go to the grocery store. As reported in this space, the ingredients for a typical Memorial Day cookout rose by double digits in the last 12 months.

And look at this. Over on the other side…what’s this? A group of vigilantes!

Yes, dear reader, they’re back…the vigilantes…ready to mount up and ride out whenever they think the Fed is being too inflationary. Back in the ‘70s and ‘80s the vigilantes won their spurs in the bond market. As soon as they saw the money supply figures creeping up on them, the vigilantes strapped on their guns and shot the bond market to pieces. Bond prices fell…forcing up yields….and thereby forcing the authorities to back off. It was bond market vigilantes who convinced the feds that the jig was up in the late ‘70s. They still had the power to inflate the money supply as they had during the ‘60s. But they couldn’t get away with it anymore. When the vigilantes dumped bonds and drove up interest rates, the economy went into such a slump, it just wasn’t worth it.

We’d been wondering what happened to the vigilantes. The feds have been increasing the money supply twice, three times…and now infinitely…faster than GDP growth. How come the vigilantes let them get away with it? How come the bond market didn’t crash? Why did they still buy bonds…didn’t they know they were going to lose money?

We still don’t know the answer. Maybe the vigilantes have grown old and too tired to strap on their six-shooters… maybe they’ve gotten Alzheimers and no longer know how things work.

But lo and behold…here they are again – in the oil market! They’ve found a new way to bring some financial discipline and monetary rectitude to the feds.

The sharp upward move in oil began at just about the same time the Fed began printing more currency, bailing out investment firms, and cutting its key rate. The supply and demand situation hadn’t changed; but the monetary situation had – and the vigilantes saw it. Rather than sell bonds…they bought oil!

Higher oil prices, of course, depress economic activity. They, along with falling house prices, are the two things pushing the United States into a slump. Usually, a slowdown would bring pain…but some relief too. Prices, notably the price of oil, would fall. But now globalization – which had been such a delight during all those years of the Great Moderation – kicks us in the derriere. Americans are forced to cut back on energy use. But the foreigners take up the slack…and then some. The oil price refuses to fall.

And the feds try to make up for it by cutting rates and increasing the money supply. They’re desperate to try to get the party going again. But then along come the crude oil vigilantes. In just seconds, they’ve pulled the plug on the amplifier and turned off the beer machine. Oil goes higher, and the economy sinks further.

Bill Bonner
The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
Bill Bonner

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Comments

  1. Bonner writes: “Oil supplies seem to be running out. Of the world’s 60 top oil producers, 54 report declining output.”

    TRUTH: Yet, because the top extractors are collecting less does not mean total output has not grown. Each year, a record amount of oil gets pumped from the earth.

    Bonner writes: “As for oil itself, there is only so much available.”

    TRUTH: Bill Bonner knows where all oil exists inside every part of the earth? Get real.

    Bonner writes: “and many experts believe the maximum annual extraction level – Peak Oil – is coming up soon.”

    TRUTH: Which experts? What are their names? What is their track record regarding the claims they make?

    Many weak-minded men suffer from false beliefs accepted as obedience to authority and experts. Is Bill Bonner one of these weak-minded men or is he a paid shill for those seeking obedient weak-minded men?

    —-

    Oil and money are commodities, one in the earth — oil — and the other made by man — (paper) money.

    Men swap commodities. Some call this swap an exchange. In truth, men swap rights, one right for another right. With oil and money, men swap the right of owning oil for the right of owning money).

    All swaps must have one commodity exchanged for another. When one thing gets calculated in terms of another, we call this a ratio. The result of the ratio, we call it a value. When we use money as the denominator, we give another name to the word value — PRICE.

    The ratio of one commodity (oil) to another (money) expresses a value, which we call a price (of oil).

    A rise in price means a change in the ratio has happened calculated at one time from being calculated at another time.

    Only two ways can achieve a price rise:

    [1] the denominator (money) rising quicker than the numerator (oil)
    [2] the numerator (oil) falling quicker than the denominator Money)

    Each year, a RECORD AMOUNT of oil gets pumped. Thus, the numerator in our ratio of oil to money is rising.

    However, since the price (the value) of the ratio is rising, only one cause can be true — a RISE IN MONEY quicker than a rise in oil output.

    Sellers sell to the highest bidder. When folks have more money bidding for a near fixed amount of oil (slightly growing in amount year-to-year), prices rise.

    Those folks whose income of money is flat or falling lose Buying Power. Since most folks have falling income, they cannot buy oil and oil-derived products as before.

    Too much money (a commodity) chasing too few goods (other commodities) — it is an age old story that happens when the lack of Credit Opportunties exist to swap money down now for future money.

    There isn’t a global oil shortage. There’s a GLOBAL GLUT of MONEY.

    What caused the Global Glut of Money?

    Money is the highest form of Credit and Credit is another word for Debt. Credit and Debt are other names for Capital.

    As credit (=debt, =capital) grows for bad products that nobody wants, a collapse of trust follows. Deals get broken and folks walk away paying on debt. Yet, the money created for this debt stays in the pockets of some folks.

    It is the default on credit (=debt, =capital) that causes problems. This increases money at a rate quicker than credit for good products, good invention.

    When credit (debt) defaults rise, the paper money and coins issued go into the pockets of winners. These winners begin to bid up prices on existing things, typically commodities of energy, metals, food.

    Why? Simply, these winners cannot find worthy investments to make, which would turn their notes and coins into capital paying a return.

    Smack MacDougal
    June 3, 2008
    Reply

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