[Mb-civic] Pouring oil on the flames

Thu Aug 19 09:53:39 PDT 2004

Buttonwood 

Pouring oil on the flames

Aug 17th 2004 
>From The Economist Global Agenda

How would financial markets react if the oil price stays stubbornly high?

AFTER a long and acrimonious dispute with his insurance company, Buttonwood
is pleased to report that his Fiat Punto is no longer being carted off to
the great garage in the sky. Your columnist has previously been scathing
about the Punto¹s attractions, the lack of which was brought home to him
recently when a friend lent him a much racier car (thank you, Juliet). But
he now realises that, for all its many failings, not least that it seems to
be as robust as a Coke can, the Punto has one big advantage: it doesn¹t use
much petrol.

Which is just as well, really, given the rising prices of oil and petrol
over the past few years. In recent months, they have been climbing very fast
indeed, and the price of West Texas Intermediate, the American benchmark
crude, is now not far off $50 a barrel. A bubble, many have said. Buttonwood
is not so sure. There are good reasons to suppose that the world will have
to get used to a high oil price for a good many years yet. Why might this be
so? And what might it mean for the price of financial assets?

OPEC, the oil producers¹ cartel, has put the blame for the rising oil price
largely on speculative excess. According to this argument, large purchases
by hedge funds, those free-wheeling pariahs of international finance, have
been responsible for pushing up the price‹witness the growth in speculative
positions on the New York Mercantile Exchange. When the hedge funds cut and
run, the argument goes, the oil price will fall. If this line of thinking
had any merit to start with, it would seem to have been somewhat undermined
in recent weeks by the fact that the price has continued to rise even as
those positions have been reduced.

In any case, long-term consumers clearly do not believe that the oil price
will fall much. When the spot price (ie, for immediate delivery) has soared
in the past, the forward price (for delivery in the future) has barely
budged, because consumers expected the price to fall again: in October 2000,
when the spot price reached $38, the forward price stayed at $20. This time,
the forward price has climbed sharply too: the price of oil for delivery in
ten years¹ time has reached $35 a barrel.

Perhaps buyers are willing to pay this apparently heady price because it is,
it transpires, not so elevated after all. Since January 2000, the average
price of oil has been about $30, points out Jeffrey Currie, head of
commodity research at Goldman Sachs. The only time in that period that it
has fallen below that price for any length of time was immediately after the
terrorist attacks on September 11th 2001.

Tragic geography

An unexpected increase in demand from a growing world economy, in particular
from China, has helped push the oil price up. So have growing worries about
supply. The world still relies heavily on exports from Saudi Arabia, an
unpleasant, apparently unstable country in a region where things are bad and
getting worse. Alas for oil consumers, the Middle East does not have a
monopoly on instability: from Russia to Venezuela, fate has decided to hide
oil under some pretty unsavoury countries. The oil price has climbed further
of late as the troubles of these two countries in particular have bubbled to
the surface.

But these supply worries reflect deeper problems of under-investment, argues
Mr Currie. There has been no growth in pumping and refining capacity since
the 1970s; all the growth in output of the past three decades has come from
squeezing more oil out of existing fields. Last year, growth in demand
outstripped growth in refining capacity by 15:1. The rise in the oil price
is both a reflection of past under-investment and, of course, a spur to
future investment. It will, however, need oil to stay above $30 a barrel for
several years to solve these supply problems.

What a high and rising oil price might mean for the world economy is the
subject of much debate among economists. The sanguine point out that the
price is still considerably lower in real terms than it was when it hit
giddy heights in the 1970s. And rich countries are, moreover, less dependent
on the stuff than they used to be. However, the more nervous, Buttonwood
among them, worry about the situation in America. An increase in gasoline
prices acts as a tax. And this sharply higher tax is being forced through
just as interest rates are rising and fiscal policy is being tightened.

 American households are already stretched, with debt-service costs at
record levels. It should therefore come as little surprise that the economy
is showing signs of weakness. The message from the Treasury-bond market,
which tends to thrive on slow growth and low interest rates, is not a
heartening one: yields are little higher than they were at the beginning of
last year. Weaker growth might, of course, translate into weaker demand and
thus lower oil prices, at least briefly. But clearly that point has not yet
arrived. And governments and companies will probably take advantage of any
drop in the oil price to build up stocks, thereby putting upward pressure on
the price.

Splitting the tab

The big question for financial markets is: who will pay the tax that a
higher oil price represents? Clearly, America as a whole will fork out in
some way because it is a net importer of oil, and the effects of the rise in
the oil price are greater there because gasoline is taxed so lightly and oil
is denominated in dollars, a currency that shows every sign of weakening
further. It is, of course, a moot point whether it will be mainly consumers
or companies who pick up the tab. In the 1970s the tax was paid for largely
by consumers in the form of inflation, which ate away at the worth of any
investment with fixed returns. But this time inflation is muted, for now at
least: consumer prices actually fell in July. This may be because, with the
world economy now so interconnected, companies find it hard to push up
prices.

If consumers do not pick up the full tab, companies will have to pick up
some of it through lower margins. There is plenty of room for them to do so
because profits are at record highs. Falling profits are unlikely to be
anything but baleful for a stockmarket that is generously valued and under
pressure from rising interest rates. Any industry heavily exposed to a high
oil price and falling consumption would not seem the most toothsome of
investments. Possibly, then, car companies and (especially) airlines might
best be taken off the menu. Shares in both have already lost around 20% of
their value this year, compared with a fall of some 4% in the S&P 500. Given
how it treats its customers, shares in Buttonwood¹s insurance company might
best be avoided too.

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