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Oil Price BubbleOmics: $90 and Rising Is the New Reality

Commodities / Crude Oil Apr 05, 2010 - 05:50 AM GMT

By: Andrew_Butter


Diamond Rated - Best Financial Markets Analysis ArticleNow that there are rumours the world economy is showing some signs of self-sustaining life (if not particularly the US Economy), one thing worth thinking about is where oil prices are likely to go (1).

Starting from the basics, there are a plenty of theories that explain how to grow economies. They range from free-markets to free-debt, all the way through stimulus-packages to free-love.

Here’s another one:

Conventional wisdom says GDP drives demand for oil.

How about if oil drives GDP?

Or in any case like it’s an essential “nutrient” for economies, like without it, they go nowhere?

Forget about how that came about or “cart-before-the horse”… perhaps the processing of oil into something else drives GDP? In other words, perhaps ultimately a big part of “modern civilization” is about making a margin on processing that feedstock into “value”?

That’s not completely insane, right now the way the world is configured, if you cut off oil supply “modern” economies wouldn’t work. It doesn’t matter how brilliant or productive a worker is, if he has to walk ten miles to get to work in the morning, the amount of “productivity” you are going to get from him, will be less than if he drives to work.

By the same token, perhaps a better measure of “productivity” might be how much GDP you get per barrel of oil, not per worker?

GDP per barrel of oil:

Looking at the chart, by that benchmark European economies, which for the most part were galvanized into looking for oil efficiency after the first oil-shock, are more “productive” than USA. They have smaller cars, higher gasoline taxes, better public transport, and more concentrated cities - as opposed to oil dependent suburban sprawl.

Extend the purple line on the chart out to $14 trillion of GDP and you get to a “theoretical” oil consumption in USA, of about one third of the current consumption, which would make them a net exporter.

But the attitude of USA in the past (and to a certain extent even now), was that they had a “divine-right” to cheap oil.  That had a lot to do with shaping their foreign policy over the past twenty years, for example an element of the decision to invade Iraq was linked to “Oil Security”, in other words “security” for low oil prices.

A trillion dollars and counting later, oil prices are nearly triple what they were when “Mission Accomplished” was first announced.

Looking to the future, it’s uncertain whether USA will be able to afford to keep that strategy going unless they can persuade China and Japan to lend them some more money.

China is interesting.

China obtains a good portion of its oil supplies from Iran, which some “hawks” in USA are proposing to bomb back into the Stone Age. This (for example) is what Senator Lindsay Graham recently had to say about that:

“Sometimes it is better to go to war than to allow the Holocaust to develop a second time. The Iran government's ability to wage conventional war against its neighbours and our troops in the region should not exist. They should not have one plane that can fly or one ship that can float."

There is no evidence that Senator Graham has managed to bring President Obama around to his point of view, but one suspects that in any case, given their dependence on Iranian oil that is an enterprise that China might be somewhat reluctant to finance.

But one would have thought that the most “efficient” exporter in the world would be more on the European (pink) line than the USA (blue) line, particularly since half of them still ride bicycles?

Although on the issue of energy (price) security, perhaps along with persuading China to re-value their currency and slapping 25% tariffs on their goods, USA can persuade them to adopt a more “moderate” and efficient “European-style” attitude to oil consumption?

After all, China just loves doing what America tells it to do.

There again, measuring China’s oil consumption is a lot easier than measuring its GDP, which in any case on the chart is expressed at prevailing exchange rates. So if the Renminbi was re-valued 25% as some people are saying it should be, in dollar terms GDP would nominally go up (i.e. move to the right on the chart) by 25%.

Another issue is that many people suspect that China’s economy is not measured “properly” when you compare to the much more structured and organized systems of the West. The main way you measure GDP is via tax returns; taxation in the West is more pervasive than in China.  Could it be that there are large areas of China’s hinterland economy that are “undocumented”, peasants working their land, even running small factories that are outside the control of the Central Planners?

China’s economy is organized into two basic camps, there are the Special Economic Zones, which have a “free-market-laisser-fair” regime (and produce 80% of China’s exports – in part thanks to foreign ownership of the production capability), and then you have the remnants of the old State-Owned production capability, which in many cases destroy economic value. Could it be that part of China’s extraordinary growth can be accounted for by closing down inefficient production capacity that destroys value?

It’s hard to know exactly what’s going on, particularly in the “hinterland”, although another good proxy for GDP is new car sales. Last year more new cars were sold in China than in USA; by that proxy China’s economy is as big as USA which would put its “oil conversion efficiency” slap-bang on the European (pink) line.

That’s insane, how could “The Ever-Vigilant-Economists” have missed that? Although there again they missed the credit crunch completely, so stranger things have happened in that “science”.

But that’s something for another day, what’s interesting is that the chart suggests the PRICE of oil ought to have something to do with Nominal World GDP (in Dollars) divided by the production (i.e. the supply measured in what was consumed (which is different from what might have been supplied)).

Big Deal – everyone knows that:

Yes, but there is a big difference between actual consumption, and the potential for supply, that’s called Parasite Economics.

Rough numbers, if you forget about 2008 and 2009 (a bubble and bust), plot from 2000 to 2007 that explains 95% of the changes in oil price.

That’s not a big surprise, everyone knows that when supplies of oil are constrained (by wars or by OPEC (if no-one cheats)), the price goes up); what’s interesting is that it looks like long-term the dynamic of the relationship is linear (2).


Going forwards, for now the World Bank is forecasting that the World’s nominal GDP growth in 2010 will be 3.8% and it will be 4.9% in 2012, that’s in US Dollars.

Assuming that number is in the ball-park (although remember it was prepared by economists, so caution is advised), that would suggest demand for oil is set to increase.

BUT – there are capacity constraints on the supply of oil (both real and artificial):

No one knows for sure how much spare capacity there is (everyone lies, even to themselves), but there is a pretty good consensus that unless some dramatic new technology is found (which hasn’t been found for the past twenty years), or unless electric cars become economically viable…still a long-way away; for the medium-term it’s highly likely that once the world economy starts to grow, demand will be in the neighbourhood of, or will exceed supply….and that will drive up prices.

This is how that all looks, assuming that the supply (consumption) of oil, worldwide, will not in the immediate future exceed the peak in 2008.

The estimate of OMV (some people call that Fair Value – I use International Valuation Standards, and OMV is what they call it), rises steeper in this analysis than the one I did six months ago (1); I think this one is a better valuation model because it’s based on the world not just USA (i.e. valuation model for OMV = ƒ(World GDP/Consumption)).

Incidentally I “calibrated” the line by figuring the “correct” value from the square root of the peak of the bubble ($147) multiplied by the lowest trough ($33), why that works is explained here (  ).

So there are two elements to the analysis (a) to get the slope and the drivers and (b) calibration; the thickness of the line illustrates (roughly) the level of uncertainty.

What’s new?

Apart from the fact that there is now some sort of optimism that world GDP at least in nominal terms in dollars, is going to go up in the medium-term, (particularly now that the melamine tainted toxic assets that the American “shadow banks” were manufacturing and distributing all over the world have started to get digested), one thing that is new for me is an explanation for what caused the recent bubble in oil prices.

I didn’t know this, but apparently George. W. Bush started buying oil for the Strategic Petroleum Reserve (SPR), that was pointed out by Philip Davis ( ).

Given that “Junior” was engaged in a trillion-dollar war that had some connection with keeping oil prices down, that sounds rather dumb.

The search for Rumsfeld’s bunkers in Tora Bora was naïve, the search for WMB in Iraq was stupid, but helping create an oil bubble using taxpayer money so Americans all paid much more for gasoline, and also perhaps had something to do with precipitating the “uncontrolled” explosion of the financial system, beats it all.

Whether the spike all the way up to $147 was all Junior’s doing, or whether Goldilocks, were standing faithfully by to deliver the coup de grace, is hard to tell.

Regardless, from the point of view of this analysis (a) it makes sense that the US government was involved in starting the bubble, governments normally have a hand in most bubbles (b) it adds a level of uncertainty since there was an unprecedented artificial demand that effectively reduced supply (I didn’t analyse that…too complicated “for government work”).

Will there be another spike?

It’s hard to imagine that the speculators will be able to gang together to create another spike without the help of “Junior”, although they do have a lot of easy money to gamble in the casino where they get a share of the winnings and the US taxpayer get’s hit with any losses, thanks to the largesse of the Fed, and TARP.

The main issue is that there is either an actual or virtual constraint on supply that is emerging. This may be physical and technical and there are plenty of people who have explained how that works, for example:

The other reason is that with an expectation of rising prices for oil in the long to medium term, it’s starting to make a lot for sense for the more logical producers to hold off pumping the stuff, and to just keep it in the ground waiting for the price to go up, rather than pumping it, taking the cash and buying a 10-Year US Treasury note at 3.8%.

When “supply” however you measure it and demand start to be of the same order of magnitude in a commodity, the opportunities for market manipulation and creation of bubbles increases.

But I doubt if someone will be able to create a bubble in oil. Lighting doesn’t strike twice, and hopefully (for USA) if oil starts to drip upwards of $100 in the next two years, the government will have the good sense to use the Strategic Petroleum Reserve (SPR) to hammer the speculators (that’s what it’s for).

The Wild-Card…Rumours of a Hard-Rain

Of course there is always the possibility Senator Lindsay Graham and his allies will get their way and that America will make sure that Iran…”does not have one plane that can fly or one ship that can float."

If they do, it would probably be a good idea not to forget in the list of “things” to be destroyed, the Russian-made 3M-82 Moskit land-based anti-ship cruise missiles (NATO designation: SS-N-22 Sunburn), a weapon for which the US Navy currently has no defence (and nor do oil tankers).

That’s because if things don’t turn out exactly as planned, (which the experience in Iraq suggests can happen from time to time even for the best-laid Military plans), worst case 30% of the world’s oil current supply would be compromised.

According to the model that would push the OMV up to $175, and the panic might generate a spike above that, (that would not be a bubble; that would be the market reacting to a new reality), and/or push down world GDP by 30% (or somewhere in the middle).

On reflection, one can’t help wondering….if someone was to arrange a little “something” to tip USA over the edge into bombing Iran back into the Stone Age, there would potentially be huge profits to be made.

A bit like the deal in Afghanistan:

All you got to do is go long oil (make sure your counterparties are solid), and put up say $500,000 to stage an “event”, set it up so the blame falls on Hamas or Hezbollah or even directly on Tehran (just like the people who were “punished” for 9/11 were the Taliban and Saddam Hussein, even though the 9/11 Commission said they had nothing to do with it), then sit back and watch the dollars pile in.

That would be much more lucrative that the profits the heroin trade made after the invasion of Afghanistan, when production soared from 20 Tons a year (after the Taliban banned it) to 800 Tons a year (that’s a business as big as Microsoft based on market cap).

The only question that remains is what sort of “event” would it take to get President Obama around to Senator Lindsay Graham’s point of view?

That’s the $10 Trillion dollar question.

I know that sounds completely absurd, but so was the invasion of  Iraq, the credit crunch, and the recent oil bubble…and come to think of it President Kennedy was assassinated pretty soon after he suggested putting a tax on gasoline in USA and promoting fuel efficiency and self-sufficiency, and even today, no one has clearly worked out “who-done-it”.

Stranger things have happened.

One thing that won’t happen:

What won’t happen is that oil prices will go down, for that to happen there has to be a bubble above OMV, not a spike mind-you, a bubble; and there is no evidence that’s going to happen (and even if it does, it will be easy to spot).

So in my opinion, betting on oil at the moment is “safe as houses” with a good upside potential and no down-side risk; particularly if there is a war.

With regard to policy, an interesting outcome of the first chart and this argument in general, is that if US could find a way to become more efficient in creating economic activity out of oil, i.e. increase it’s “oil-processing-efficiency”, it might be able to achieve economic growth (and jobs) a lot faster and cost-effectively, than for example, money borrowed from China and Japan or printed by the Fed at “stimulus packages” and government-employed bankers, and/or paying for new wars in exotic new locations.

Just a thought…

 (1): Notes:

For the record the first analysis I published on oil was last April when it was about $50. My “prediction” then was that it would go up to a “nice round number”, in the order of $100 by end 2010 . In early June I said the $75 Saudi target looked cheap , and in July I said the idea of a pullback to the lows of early 2009 was ridiculous (  in October I said it would reach $90 by end 2010 without any significant reversals

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2010 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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