Peak Oil News: Open shift to the Euro would further lock-in higher oil prices

Tuesday, May 17, 2005

Open shift to the Euro would further lock-in higher oil prices

Andrew McKillop oil industry commentarist Andrew McKillop writes: The US economy attained it highest-ever postwar annual growth of real GDP, achieving what today would be the impossible all-year rate of 7.5%, in the Reagan re-election year of 1984.

At the time, in dollars of 2004 corrected for inflation and purchasing power parity, the oil price range for daily traded volume crudes was about US$55-68/barrel.

Today, with oil prices that show extreme volatility -­ likely because of underlying physical shortage -­ but are close to $50/bbl, US economic growth on an annual base remains above 3.75%, and achieved more than 4.5% on an annualized base, in 2004, with oil prices that regularly exceeded $55/bbl.

World economic growth in 2004, on IMF data published in early 2005, was the highest for over 15 years, at about 4.8%, despite -­ or because of -- oil prices attaining $55/bbl, also entraining record high prices for most metals, many minerals, and some agro-commodities.

As oil prices have increased, economic growth rates in all regions of the world except Europe have not fallen, but significantly increased through 2004. Both in oil-importing low income countries of Africa, and oil-importing countries of Latin America (especially Brazil) economic growth in 2004 strongly rebounded from the lows of 2002-2003, surprising many analysts. World merchandise trade growth in 2004 was running at its highest rate for over 15 years.

Due to this 'vintage economic growth', world oil demand growth is also at 'vintage' rates, estimated by the OECD IEA at 2.68 million barrels per day (Mbd) for 2004, on an 'all liquids' base.

Despite the simple economic facts, however, current oil prices are described by J-C Trichet of the European Central Bank, and other major players as 'extreme', claiming that they will 'inevitably hurt economic growth', through increasing inflation, which will entrain defensive interest rate hikes.

Cheap Oil is still regarded by the uninformed, the ignorant and the biased as a passport to economic growth, when it is in fact the opposite -- cheap oil slows economic growth, notably through depressing commodity prices and reducing world liquidity. Much higher and stable oil prices are a necessity for any progress towards the urgent task of energy transition away from fossil fuels.

The arrival of Peak Oil, or the absolute peak of world oil production, almost certainly by or before 2007, will drive home this message.

On the supply side, so-called 'muscular strategies' for increased export offer can be supposed to have entered into American and British planning for the Iraq 'regime change' war.

However, regime change in Iraq has produced no long-term stable result, oil production and export offer is down, and the entire US-UK neoconservative policy of 'spreading democracy' by massive military invasion in the Middle East is likely to start and finish with Iraq.

* The Iraq war, described by UN Secretary-general Kofi Annan as illegal, will bring no bonanza, that is large new oil production and export capacities, in either the short or medium-term.

On the world supply side, there is little avail and remedy in a context of strong and 'surprising' world oil demand growth. Apart from Saudi Arabia and Russia, both of which are threatened by internal ethnic and religious conflict and are both unable to raise production except on paper and in increasingly unrealistic press releases, the only prospects of increased oil supply are from small West and Central African producers, Central Asian and Caspian region producers, and by smaller Mid-East OPEC producers.

Regarding production technologies, deep offshore production in the Gulf of Mexico and southern Atlantic, and 'unconventional' synthetic oil production, mostly in Canada and Venezuela, will very surely have to increase at a rapid rate.

For economic and financial feasibility this requires high and stable oil prices. The general context is therefore totally negative for the "return of Cheap Oil".

Neither OPEC nor Russia, Norway and Mexico (the biggest non-OPEC producers with export surpluses) can deliver much, or any more oil, because they are close to, or at their physical limit of capacities. Because of this, upside potential for oil prices remains strong. Any use of 'Tomahawk democracy' in Iran or elsewhere will result in 'oil price explosion', to above 100 USD/bbl and the start of major financial and economic crisis at the world level.

The bottom line is that energy transition, featuring large and rapid decreases in the oil intensity of OECD economies will -­ very soon -­ be impossible to sideline as a utopian project.

Increasing realism -­ no more 'supply side answers'

The G-7 finance ministers group reacted, in May 2004, to prices moving and staying above 40 USD/bbl by 'solemnly' calling on OPEC to rapidly increase output and force down the price. Since then, and especially because oil prices are now at a 'floor price' of around $50/bbl, this 'supply side solution' to the fact of higher priced oil is giving way, grudgingly and slowly, to realism.

Durable solutions to the growing threat of world oil markets being faced with long-term or 'structural' undersupply, followed not so much later by world gas supply peaking, must and will include treatment of the demand side. In this context, real and committed long-term energy supply adjustment, and energy economic infrastructure adjustment and adaptation strategies must be dusted off from their 'antique' status, and brought forward. In other words energy conservation, efficiency raising, transition to renewable energy, and restructuring towards a low energy economy, habitat and society.

* Reduction of the oil intensity (measured in barrels/capita/year) of the economy and society must become an urgent goal for leaderships of the high-energy OECD nations.

For some 18 years or so, since the oil price collapse of 1986, most energy economic alternatives to the fossil energy-based, high consumption, throughput economy have been discarded as utopian or unworkable by the vast majority of OECD political decision makers.

The only other solution -­ 'demand destruction' through economic rout Without strategies for an 'energy lean' economy and society, there is only one method and type of economic adjustment to oil prices that can at any time move very fast to 'exotic' highs under the force majeure of geopolitical instability in the Mid East, in Central Asia, in Africa, or elsewhere.

This economic adjustment would be through using the 'interest rate weapon', generating so-called demand destruction through intense economic recession. Economic 'adjustment' through destroying demand, by self-imposed recession is a tried-and-tested strategy.

The last time it was used widely in the OECD countries, in 1980-83, the impact was surely to reduce oil prices (in 2005 dollars from a peak around $110/bbl in late 1979 and early 1980, to around $60/bbl in 1984), but the collateral economic and social damage was awesome. In addition, the actual oil savings generated by this self-imposed recession was no more than about 9.6%, concentrated in the 3 years of most intense recession (1980-82), with oil demand continuing to grow again the moment world economic growth was restored. Unlike today, the OECD economy entered this 'adjustment-by-recession' with balanced budgets in most countries, including the USA, in 1979-80.

The financial, economic and geopolitical risks, today, from recourse to 'the interest rate weapon' are almost open-ended.

The interest rate weapon would backfire, today

Things are very different today...

* No 'soft landing' is currently on offer.

The world economy is driven by intense growth in the emerging industrial superpowers of China and India (and other large population industrializing economies such as Brazil, Iran and Turkey), in a global economic context of increasing economic growth.

In the case of the USA, generating about 30% of world GNP and taking about 30% of world oil imports, both public finance and trade deficits are now at all-time record high extremes.

As a result the US dollar is highly exposed to any downturn in US economic growth or further increase of the so-called Twin Deficits, that is federal finance and national trade deficits. Long inaction to stabilize or reduce oil intensity of the economy in the most oil-intensive economies and societies (USA, Europe, Japan, Asian Tigers), has resulted in ever-rising oil import dependence on shrinking world export offer, with nearly unlimited upward potential for oil import demand of China and India. This has generated a context in which continued increases of the oil price are virtually certain, if there is no quick-acting and deep economic recession.

Despite the somber warnings of 'recession due to high oil prices', a return to oil prices of 1984 (up to $60-70/bbl), would do little to harm the world economy. High oil and energy prices quickly raise world solvent demand through increasing revenues from production and export of 'real resource' commodities (energy, metal, mineral and agricultural) by mostly low, or very low income countries.

* Greater use, and purchase of US$ for settlement of oil and commodity trading also favors economic and trade growth, while shielding the US dollar, to some extent, from rapid erosion of value against other currencies.

Conversely, hiking interest rates, in today's economic and financial context, would result in near-instant world economic and financial crisis. The interest rate weapon, today, would surely entrain complete collapse of world stock markets, severe financing problems for so-called 'emerging economies', runaway domino effect bankruptcy of many major service and finance sector corporations, mass layoffs and unemployment in the OECD countries, and grave problems for financing the structural trade deficits of especially the US and UK.

The US would expose itself to perhaps uncontrolled flight from the dollar as the interest rate weapon firstly produced stock market collapse, with inflationary recession as the likely outcome.

The currently unstable US dollar, subjected to 'benign neglect' in its unequal struggle with the Yen and Euro, could in this scenario perhaps suffer uncontrollable flight and fall below 0.70 Euro. The declining petro-money status of sterling, as the UK inexorably returns to being a major oil importer country, would unlikely shield the UK economy from the sequels of the interest rate weapon being used in the OECD group of economies as a blunt tool of energy policy, to force down oil demand.

Oil prices will remain high

For many reasons, underpinned in final analysis by the approach of the ultimate peak in world oil production capacity and output, oil prices will remain on a volatile, erratic but fundamentally upward trend.

As noted above, the interest rate weapon for reducing oil prices through entraining a recession in fact, and a so-called 'soft landing' in theory, should be out of the question at this time.

Thus the 'very high price of oil' that has held, off and on since 1999, will necessarily be tolerated and accepted by economic and monetary deciders for the simple reason they have no other choice in the short- or medium-term.

Other energy economic strategies and responses must be utilized. In addition, the supposed 'inevitable recessionary impact' of high oil prices is nowhere to be seen -­ what is seen and noted, every day, is the fact of record economic growth in East and South Asia, and high if unstable economic growth in the USA, increasing growth in East Europe, and rapid recovery to growth of the Russian economy.

Aborting this process through use of the interest rate weapon would be a nearly suicidal experiment in strong-arm energy policy, with instant destabilizing geopolitical consequences, extending to possible all-out nuclear war following world financial and economic crisis.

* Upward potential for oil prices is in final analysis driven by surging world oil demand. This has attained well above 82 million barrels/day (Mbd), and is now in May 2005, probably above 83 Mbd. The underlying rate of growth is likely well above 2.5% annual.

This is far above the 'long-term trend rate' of about 1.4% annual that held through about 1989-96, but which the IEA and BP Amoco, among others, have erroneously claimed as the "10-year underlying growth rate trend" for 1990-2000. In fact, and by 1996 at latest, world oil demand growth started to break out of its slow growth trend, and has dramatically increased, with rising oil prices, since 1999.

Oil demand growth trends are well over 5%/year for all of East and South Asia, above 4%/year in East Europe, and probably close to 3%/year for the USA. The net result of this is that world oil demand will continue to grow by much more than 2 million barrels/day each year. This is close to double the rate of the early 1990s.

Concerning imports, world oil import demand will remain well above the consumption growth rate number (due to depletion) and can be estimated at a trend rate of close to, or above 3 million barrels/day each year.

Probably 60% of the world's remaining oil is held by the Middle East 'core' nations of OPEC, that is including Iraq, whose potential for production increase has effectively been sabotaged or heavily delayed by military 'adventure' and 'regime change experiment'. The war of communiques between OPEC (understating both production and demand), and the big consumer nation economic and energy agencies like IEA and EIA (overstating inventories while overstating production, especially outside OPEC) can surely go on, but the degree of unreality in this now ritual game can only increase.

An open shift to the Euro by more members of the cartel would by the magical irony of the oil market itself further lock-in higher oil prices.

At present the only bottom line of which we can be sure is that almost no credible scenario re-enables oil prices at the 1990s 'target price' of $18/barrel, or the most recent 'preferred price' of $22-28/bbl. A new 'effective price range' of about $50-70/barrel, that is about Euro 40-55/barrel may well arise, until and unless the 'interest rate weapon' is used to trigger a self-imposed recession in the OECD nations, with almost open-ended risks for world stability.

No easy alternatives

Some analysts argue the highest-ever one-year growth of the US economy in 1984 was due to equally extreme budget deficits operated by the Reagan administration with the aim of securing Reagan's re-election.

* The current Bush administration is now running 'twin deficits' well above the previous records set by the Reagan administrations.

This 'good economic management' did indeed produced enough economic growth in the US in 2004 to ensure the re-election of G W Bush, but the impact on oil prices of US, Chinese, Indian, East European and Latin American economic growth will not taper off, as happened immediately after the Reagan re-election boom of 1984.

Oil prices at levels close to those of 1984 are now 'structural', and most likely the plateau for take-off to real record high prices. The underlying basis for this is world oil production capacity being unable to track surging demand, oil depletion accelerating, discoveries lagging far behind annual consumption, and the lack of both initiatives and activity to reduce oil intensity of the economy. In real terms oil prices are still below their highs of the 1980-83 period.

The real limiting factors on faster economic growth in most OECD countries do not include oil prices, but personal debt, delocalization and de-industrialization, aging populations, fears of job losses, terrorism, climate change and other worries in what are essentially consumption saturated economies.

There are ever fewer possible strategies for restoring conventional economic growth in the aging democracies of the OECD group.

So-called 'de-growth' towards a sustainable economy and society are in fact the sole logical responses to this predicament. This strategy, if intensively developed, can quite rapidly reduce oil intensity of the OECD countries, which will buy time for the giant industrializing economies of Asia, who for some time will be forced to increase their oil burn.

Unless the OECD countries rapidly adopt oil saving and oil intensity reduction policies and programs (which can be modeled on Kyoto Treaty provisions), the potential for terminal energy crisis, or unlimited growth of oil prices, will remain a distinct possibility.


For various economic doctrinal and economic mythical 'reasons' Cheap Oil is seen by the decision-making elite in the richer nations as the 'passport to economic growth'.

This is a pure fantasy...

Cheap oil and energy underpin the service oriented 'globalized' economy which drives the urban-industrial reference format, model and framework for economic development and social progress anyplace in the world. This in turn is a powerful motor for continued and strong demand growth for fossil energy, worldwide. Upward potential for personal consumption of fossil fuels is essentially unlimited in this context.

Physical depletion is either rejected or ignored as a price setting factor for oil and gas. Concerning oil there is mounting evidence that net additional production capacity is decreasing every year and may soon fall below the product of new capacity demand + annual lost capacity.

By 2007-2008, and perhaps before, structural supply deficit will be a reality on world oil markets. Before that, loss of export capacity through accidents, stoppages, sabotage or war will produce recurring price 'spikes'.

Conventional or classic economic growth will be enabled and facilitated at the world or 'composite' level by rising oil prices, even to $60-70/bbl.

Also because of depletion, but in addition because of environment and climate limits, energy transition away from fossil fuels must and will happen.

Price signals, in the existing economic system and framework, are needed if this is to start, and to build from the immediate near term.

Existing and developing frameworks provided by the Kyoto Treaty offer some potential for adaptation and direction to the task and goals of energy transition.

Andrew McKillop is an energy economist and consultant who recently edited a book for Pluto Books, ISBN 0745320929, title 'The Final Energy Crisis' including articles by Colin Campbell and Edward R D Goldsmith. He has held posts in national, international and supranational (Euro Commission) energy, and energy policy divisions and agencies. These missions have for example included role of Energy policy coordinator, Dept Minerals & Energy, Govt of Papua NG, advisory and management at the AREC technology transfer subsidiary of OAPEC, Kuwait, study missions at the ILO and UNDP, in-house consulting to the Hydro & Power Authority of British Columbia, Canada, seminar presentations at the Administrative Staff College of India, Hyderabad, study and technology review at the Canada Science Council, and elsewhere. Andrew is a regular contributor to; he was first energy editor of the journal 'The Ecologist' and has co-authored published works with other analysts, e.g. 'Oil Crisis and Economic Adjustment.' Pinter Publishing, with Dr Salah al-Shaikhly, currently the Interim Iraqi government's Ambassador to London. He is actively seeking research, consulting or writing missions at this time. You may contact Mr. McKillop by email at -- telephone London UK +44/ (207) 288 0475


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