By Economic Strategist, Hottinger Investment Management
When it comes to the importance of oil to the global economy, few have expressed it better than the Scottish novelist James Buchan. In an article for The New Statesman in 2006, he wrote:
“A century ago, petroleum – what we call oil – was just an obscure commodity; today it is almost as vital to human existence as water. Oil transports us, powers our machines, warms us and lights us. It clothes us, wraps our food and encases our computers. It gives us medicines, cosmetics, CDs and car tyres. Even those things that are not made from oil are often made with oil, with the energy it gives. Life without oil, in fact, would be so different that it is frightening to contemplate.”
In the twelve years since, some of the technologies have changed but the triumph of oil has only advanced. Since 2006, according to the International Energy Agency, global oil production from all sources – including shale, oil sands and natural gas liquids – has risen by over 12% from 82.5 million barrels a day to just under 93 million barrels a day. About half of that increase has come from China with other emerging economies driving the rest.
It’s no surprise, therefore, that analysts and economists still look to the oil price as a guide to the fortunes of the global system. Helen Thompson of the University of Cambridge is a specialist on the political economy of oil, and has built her thesis around an astonishing fact: All but one of the recessions in the United States have been preceded by a sharp rise in the price of oil, not just those that were specifically caused by OPEC in the 1970s and 1980s (see chart, recessionary periods in red), though that is not to say that all oil price spikes cause recessions.
In the eighteen months before the Great Recession, Brent Crude trebled in price, from around $50 per barrel at the start of 2017 to $150 per barrel in July 2008. It is not unreasonable to think that price pressures from oil caused the Federal Reserve then to tighten too quickly, seizing up credit markets at a time when banks were running amok.
This provides pause for thought for those wondering whether the global slowdown could become more severe. The current down trend in the price of oil could reflect weakened demand from emerging market economies that have been hammered by the combination of the rise in the price of crude from about $30 per barrel at the start of 2016 to $85 this May and the strengthening of the dollar. A more sanguine view, however, would suggest that the introduction of new sources of supply has kept oil prices manageably low levels and reduced the risk of global recession in the immediate future.
While we now talk of demand for oil peaking sometime in the middle of this century due to the rise of alternative forms of energy and awareness of climate change, in the mid-2000s the fear was of peak oil supply. This was because discoveries of conventionally produced oil – that is, oil produced by drilling and pumping – had been falling (and continues to fall), and the many of the places where substantial reserves exist – such as Iran, Iraq and Venezuela – were not exactly conducive to the requirements of the global economy. That was the fundamental reason why oil prices spiked so much in the years up to the Great Recession. New sources of supply were yet to come on stream and global demand was soaring.
Oil prices have not returned to the heady heights of 2008, and indeed have broadly fallen since 2014, because the introduction of shale, tar sands and natural gas liquids onto the market has more than met the increase in demand from the emerging countries. In 1990, just over 90% of global oil was sourced from conventional processes; in 2013, that figure was just 80% and it has likely fallen further since (see chart). This increase in supply has been driven largely by the US, enabling that country to not just become energy independent but to exceed the volumes it achieved in the 1960s and 1970s when its conventional oil industry was at its peak and producing up to 10 million barrels a day.
When oil prices become too high, they put pressures on consumer spending and induce central banks to raise interest rates to keep inflation under control. This happened in 2008 and 2011, catching out the European Central Bank which responded to rising inflation by raising rates in an environment of weak demand, arguably deepening and lengthening what we call the ‘euro crisis’ of 2009-2015.
But the development of shale has, however, created a very different problem. Due to the rise of production from these high-cost alternative sources, oil prices can create problems for the economies that are dependent on these sources when prices become too low. When prices become too low, analysts start worrying about the fortunes of highly leveraged shale producers which borrowed when QE made credit cheap, which have invested in expensive capital-intensive infrastructure at a time when oil prices were high, and which rely on high prices staying high to break even. It is commonly thought that $40 a barrel is now the price below which shale producers start making losses, and there are concerns that the surpluses that are building up in the oil market could push the oil price down further towards those levels.
According to Thompson, the issuance of high yield bonds by US companies in the energy sector trebled between 2005 and 2015, and the value of syndicated loans to the oil and gas sector increased by 160% between 2006 and 2014. While oil prices don’t present the same direct risk to the global economy as they did in 2008 because they are relatively low, they do – precisely because they are low – to the US economy, whose central bank continues to raise interest rates at a pace that the market thinks is too fast for highly levered firms such as shale producers to handle.
Together with concerns around corporate credit more broadly in the US and the significant exposure to it of European banks, we should keep a close eye on the oil price if it continues to trend down.
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