National Commentary

The Peak Oil Crisis: $80 a Barrel

Last week oil broke out of a months-long trading range and surged to $82 a barrel. For many of us who remember $140 oil from the summer of ’08 this might not sound impressive until you are reminded that every time oil (adjusted for inflation) broke $80 a barrel some sort of economic recession occurred.

In the wake of the breakout to the upside, the financial press is full of stories talking about $95 or $100 oil this winter.

The general theory behind all this is that an economic recovery led by China is occurring right now. To hear Beijing tell the story, their economic stimulus and loose lending practices worked like a charm so that China will soon be leading the world to self-sustaining growth.

The international forecasting agencies are already talking of a jump in demand for oil next year which will put worldwide consumption back in the vicinity of where in was in 2008. Given that the world has only 2 or 3 million (or if you are optimistic 4 or 6 million) barrels a day (b/d) of spare oil production capacity and that it is taking all the industry can do to keep up with the roughly 4 million b/d that depletion is taking away each year, we will see tight oil supplies on of these days.

If this scenario plays out there will be much higher oil prices. We can’t have it both ways. It will either be a really deep global recession and cheap gas or some sort of start at recovery and spiking oil prices. Discussions have already started as to what level of oil prices causes serious damage. In the past an inflation adjusted $80 a barrel was a favored recession inducing number as this was the price that seemed to cause recessions back in the 1970s and 80s when Middle Eastern wars and embargos restricted supplies.

The trouble with $80 oil, of course, is that we are already there and no analyst that draws a paycheck from Wall Street wants to say flat out that another leg of a recessionary downturn is inevitable unless oil prices decline soon. A typical example was a Dow Jones story earlier this week entitled “Oil Price Rise Poses Little Threat, Yet, To Economic Recovery”. The article points out that the danger to economic recovery won’t start until we get to $90 or $100 a barrel or $3 a gallon gasoline.

For the time being, however, oil prices do not have as much to do with supply and demand as they did in days gone by. There is enough reserve capacity in the Saudi Arabia and the Gulf states to increase production by anywhere from 2-6 million b/d (depending on who you ask), so  for the time being unless some major geopolitical event intervenes, oil prices seem to be tied more closely to the fate of the dollar.

As the dollar goes down vs. other currencies, oil prices go up. It does not seem to matter how much oil is building up in storage or how fast we are burning gasoline. For the time being, the dollar is in the driver’s seat. Given the unprecedented amount of deficit spending and federal borrowing that is likely to be going on for the foreseeable future, the outlook for the U.S. dollar as a world currency does not look that bright. The U.S. plans to sell at least $118 billion worth of government securities before the end of next month. Looking at numbers like these some analysts are convinced a further decline in the dollar is inevitable no matter what the Federal Reserve does to mitigate the situation.

The current situation is clearly unsustainable. If the dollar continues to sink, oil is going to move so high that all sorts of economic consequences are inevitable. OPEC is already in a dilemma for no matter how much they like the increasing revenues, the smarter governments realize that if prices move much higher, it will trigger off even worse economic times.

In recent days, a new discussion has started as to just how much weaker the U.S. and OECD economies will be this winter as compared to the spring of 2008. Eighteen months ago oil prices had to spike well above $100 before the consequences became generally noticeable. This time around, with unemployment much higher and industrial production and retail sales much lower, concern is growing that it may not take much more of a price increase before retail sales take another dip.

Conventional wisdom holds that a national average of $3 a gallon gasoline (California is there already) is a psychological turning point where many stop visiting auto show rooms, cut back even more on driving, and become more fearful of making discretionary purchases. Here, in America we are currently going through roughly 800 million gallons a day of oil in one form or another. This means that for every 10 cents the price of gasoline and other fuels increase we collectively have $79 million a day, $550 million a week, or $2.4 billion a month less to spend on other things. As very few of us are running up our credit cards or obtaining other forms of loans these days, purchases will inevitably diminish.

Keep watching your gasoline prices. Serious troubles may be closer than many want us to think.