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Crude Oil And Inflation Economic Crisis

Commodities / Crude Oil Feb 29, 2012 - 12:01 PM GMT

By: Andrew_McKillop

Commodities

Best Financial Markets Analysis ArticleConventional wisdom says high oil prices raise inflation and slow down economic growth. Recessions are therefore caused anytime oil prices spike, we are invited to believe. In the real world, European Central Bank president Mario Draghi has lowered interest rates twice since he took over as head of the ECB in November, as oil prices went on rising, but economic and finance observers claim that keeping borrowing costs down will get harder as oil prices cruise to record levels in euro terms.


European benchmark Brent is at a record 82 euros, this week, topping the 2008 price peak, in euros.

Commision president Jose Barroso, and French leading presidential candidate Francois Hollande have continued saying "growth is the answer" to Europe's debt-and-deficit crisis and fast growing unemployment. The oil crisis argument is this needs further rate cutting, but rising oil prices will make this impossible because oil price hikes stoke inflation. In a high oil price environment, observers say, the ECB may be unable or unwilling to cut rates at the pace the market is pricing, and may hike interest rates and push Europe into deeper recession, with an inevitable slump in equity prices.

OIL AND RECESSION
The low real interest rate environment in Europe is little different to the US or Japanese situation - for the few EU countries running a trade surplus, led by Germany. The yield on its 10-year index-linked bunds has fallen from minus 0.11% in January, to minus 0.20% today, and German 10-year federal borrowing costs remain at a highly modest 1.82% per year. Oil and recessions have such complicated relations that as this chart suggests: in recession, oil prices can be high, and can be low.



Alternately, we would need to say that a tight and real relation between oil and recession is shown by the US economy "rebounding" almost exactly from December 2008, pulling up oil prices with it. How many US economists would support that reading of the Obama ride into debt, deficit and social conflict since 2009 ? Did the US economy start growing from the end of 2008 ?

Likewise, inflation rates, and oil price rises and falls have few straight or direct relations, shown by Eurozone inflation now officially running at 2.7% pa, against the ECB's proclaimed target of 2%. Inflation in Europe has risen, and oil prices have risen, but in many ways the official rate of inflation, like the similarly low official rate for the US, is a miracle given the QE printing and hand out of easy cash - for the finance, bank and insurance sector. The real question is: why is inflation so low ?

Put another way, the Obama administration's budget deficits, attaining about $1.6 trillion per year, and its raising of US debt by around $7.5 trillion in less than 4 years is enough to cover around 25 years of the gross costs, before oil trade gains, of all US oil imports (of around 8 million barrels per day), at a 'sticker price' of $110 per barrel.

To be sure, as a constraint or far outer limit on economic growth, extreme high oil prices, or oil prices that suddenly increased by a large amount might fill the bill. But as direct drivers of global macroeconomic change we have to look elsewhere. Taking the European case, EU27 imports of all forms of energy - oil, gas, coal and uranium - cost about 350 billion euro in 2011. This was a princely total of 3% of EU27 GDP in 2011. The real causes of inflation and recession are elsewhere.

Not looking elsewhere is the game in many places, helped by oil prices in dollars that have advanced about 10% this year on concern that Iran bombing will shift from its 10-year itch status, for bombing partylovers and war criminals, to real world action. In Europe the price push is being made more real by the EU embargo on Iranian oil, depriving countries like Greece, Italy and Spain of serious amounts of real oil from Iran. Seeking supplies elsewhere, this automatically pushes prices higher.

WHERE AND HOW DOES OIL INFLATION HIT ?
The ECB, whose primary job is to fight inflation, left its benchmark interest rate at a record low of 1 percent this month, but observers suggest it may even raaise rates if oil prices go higher. Interestingly enough, and showing the critical mismatch with the supposed driver - oil price trends - the ECB's last major hikes of interest rates was from July 2008, at the near exact moment when Nymex oil prices attained their ultimate peak of around $147 per barrel, and started rapidly declining. At the time, the ECB's then president Jean-Claude Trichet was applauded for his willingness to raise rates as if in anticipation of the Lehman Brothers shift into bankruptcy protection. He was supposedly fighting oil-driven inflation, at the same time as he really sealed the fate of Europe's slide into recession.

The ECB rate hikes of 2008 were claimed to be driven by anticipating that higher commodity prices would automatically drive inflation, but what we find is that countries like Germany, with lower unemployment and low inflation, will see inflation rise when oil prices rise. Conversely, countries with higher unemployment and high, but well-hidden inflation like Greece, Spain, Portugal and Ireland will likely not see a rise in inflation. The link is clear: oil demand is higher in countries with tight labour markets and high incomes, making the inflation feed-through from high oil prices real.

In fact and as we know, the real limit on either the US Fed or the ECB hiking rates - supposedly to counter inflation caused by oil - is social unrest against a backdrop of government spending cuts, austerity measures and tax increases. Just as important, oil price rises feed back inside the energy industry, as rising E&P and infrastructure costs, and oil services costs.

These are all basically driven by peak oil

The OECD's energy agency, the IEA, has juggled the numbers in heroic fashion for at least 4 years, following the predictable oil price explosion of 2007-2008. Basically admitting that "conventional oil" output will decline from the 2010-2012 period at rates as high as 5% a year on a sustained long-term basis, unless oil sector spending rebounds and stays high, it also foresees a stay of execution from rising "unconventional oil" output. The definition of this is variable, but can include tarsand oil, shale oil, coal-to-oil conversion, gas conversion, biofuels, deep offshore oil, heavy oil, and others. In every case the key adjective is "non-OPEC", underlining the relentlessly increasing dependence on OPEC's unlikely to expand maximum net export capacity, about 31 million barrels/day, of mostly lower cost "conventional oil". Reliance on OPEC will tend to drive oil prices higher and further, for one reason because OPEC is also facing a decline in discoveries and facing steep-rising production costs.

SAVING THE OIL AGE
Unconventional oil from outside OPEC is therefore set as an "oil age stretcher" or Civilization  Saver without adding the bottom line: unconventional oil is not cheap. The difference between shale gas production costs, and shale oil production costs is high and is due to basic industrial and technical reasons. As oil gets more expensive, this feeds back as a constant move to tapping marginal, higher cost and "exotic" oil surces, using extraction and production technologies that usually have high environmental costs and risks, such as tarsand, shale and deep offshore oil, and always deliver lower "net energy".

More energy is used to produce the 1600 kWh of energy in each barrel. This is why "unconventional oil" costs more and will go on costing more.

The radical double-digit annual cost inflation in the oil sector through 2003-2008 was itself driven by peak oil and the recourse to marginal and exotic oil sources, and high oil-intensity, low net energy subsitutes, like the biofuels. These, through driving food price inflation help insure that rising oil prices can trigger general economic inflation, when the right number of conditions are together. The claim today by anti-peak oil civilization savers is that after the 25% slump in global oil sector capex in 2008-2009, it is now rebounding and will likely attain. $450 billion in 2012 - and this capex will produce more discoveries of "new oil" than previous.

This theory heavily depends on US shale oil plays and claimed recoverable reserves - but with production costs around $70 per barrel and final oil prices likely near $100 per barrel as operators of this "lifeline oil reserves" struggle with spiralling concession costs and lease prices.

The basic argument of peak oilers some 10 years ago, that a stepwise rise in oil prices is coming, is confirmed by the New Theory that oil is abundant - if and when you pay $100 per barrel.

The Citigroup peak oil denial team's report of 15 Feb 2012 has one basic thesis: that is a "migration" from shale gas expansion, to shale oil expansion. It claims that what worked for shale gas will work for shale oil. It also makes claims that US shale oil output is able to grow by "up to 2 million barrels/day" by 2020, but this is only equal to a 2% growth in world oil demand: through 8 years we can expect an awful lot more than that, worldwide. We can also expect serious and continued decline in conventional oil output, despite the maybe temporary rebound in oil sector spending. Star players in the Citigroup's answer to Thomas Malthus heavily feature the US Bakken and Eagle Ford shale oil (and shale gas) basins. Taking their probable total oil reserves to be the Citigroup report's claim of 7.1 billion barrels, we find this amount of oil, if it is completely extracted through as long as 25 years, will cover less than 1 year of US current oil consumption, running at about 19.5 Mbd.

Probably thrown together as a nice way to reassure the business community that cheap oil is now set to join cheap gas - at least in the US - the claim that shale oil can and will replace present conventional oil is no more credible than the claim that high oil prices  directly generate inflation and cause recession.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2012 Copyright Andrew McKillop - 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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