Oil…. To The Moon?

Much of the current debate regarding the future of commodity prices, particularly oil, hinges on the continued strength of the developing world. This, itself, is a presumption, and it may not be the sole or even primary determinant. To be sure, much of the rise in energy and non-energy commodity prices has reflected the surge in demand from the emerging markets and the inadequate and very-much lagged response of commodity suppliers. Resource prices were so low for so long, that many producers simply shut down or refrained from high-cost resource exploration or mining. It is only since oil moved well in excess of US$35 a barrel that many of the players in the Canadian oil sands have found it economically feasible to mine oil from bitumen. And they wouldn’t be doing it now if they didn’t expect oil prices to remain high for the indefinite future. Many, far more expert than I, suggest that global oil supplies will be increasingly inadequate in coming years.

David Goodstein, vice provost and professor of physics and applied physics at Caltech, makes a compelling argument in his book, Out of Gas, that the world will be running on empty from an oil perspective well within the next decade. Kenneth Deffeyes, professor emeritus at Princeton University and author of Beyond Oil, makes a similar case suggesting that the global supply of oil is peaking and will face an inexorably steep decline in coming years. He does include an analysis of natural gas, coal, tar sands, heavy oil shale, uranium and hydrogen.

So the issue comes down to price. Rising oil prices do reduce demand and economic activity generally in non-oil producing sectors and countries. Oil leads by roughly one year. When oil prices surge, non-energy commodity prices typically also increase. We have certainly seen that this cycle. This is because the global demand that drives up energy prices also drives up other commodity prices. These price increases combine with strong global economic activity to create inflation fears. This usually prompts central bank tightening, that is, rising interest rates, which slows global growth—all with a lag. From Asia to Europe and the U.S., higher oil prices are lowering the prospects for global growth, even in the developing world.

To be sure, G-7 growth is slowing, and so is emerging market growth. The developing world is growing at twice the pace of the developed world, it represents 87% of the world’s population, and it uses twice as much raw material per dollar of GDP than the G-7; in the case of oil, usage is roughly three times as much. China is now the largest consumer of cement, iron ore, steel, aluminium, tungsten, and coal. It is the second largest consumer of energy at 12% of the global supply. But developing economies represent only one-fifth of global GDP. The combined industrial production growth of China, India, Brazil and Russia—the four largest developing economies—is slowing and the U.S. consumes 24% of the world’s supply of oil, twice the level of China. So the more the U.S. slows, so will American consumer demand for Chinese and other foreign imports; the bigger the U.S. slowdown emanating from rising gasoline prices and interest rates, the bigger the slowdown in China and the rest of the world. This is the equilibrating mechanism that the triple-digit oil price crowd plays down. Or, at least, if oil hits triple digits, it will soon be on its way back down to $30 a barrel.

For sure, the supply-demand fundamentals are very favourable today for energy and base metals prices. The supply of aluminium, for example, is nowhere near the current and near-term demand. So prices will rise, but not to the moon, and not forever.