Financial Daily from THE HINDU group of publications
Monday, Aug 16, 2004
Columns - Global Finance & Overview
The coming global recession in 2005
V. Anantha Nageswaran
THIS column has, in the last few weeks, commented on the unrealistic optimism of the Federal Reserve chairman on the state of the American economy. One smart commentator called upon those with a penchant for wishful thinking to join the Fed or an investment bank, he should have added, for in recent times, the Federal Reserve governor had begun to sound more like the chief economist of a Wall Street investment bank.
Shockingly high American trade deficit in June
However, it was truly Friday the 13th for the American economy and for the Fed because US trade deficit for June exploded. Not only was the trade deficit for May revised higher from $46 billion to $46.9 billion, but also that for June at $55.8 billion was well above consensus estimates. University of Michigan consumer confidence was lower than expected and West Texas Intermediate Crude Oil price closed at $46.58 a barrel. That is an appreciation of more than 43 per cent from the end-2003 close of $32.52 a barrel.
This has been our refrain all along. Either the US economy loses momentum and heightened interest rate expectations are unmet or the US economy continues to sizzle and pushes the trade and current account deficit relentlessly higher, placing even greater demand on global savings to finance American consumption.
Dollar to be hurt by low yields and high deficits
In either case, the inevitable result is a much weaker dollar. That trend has just resumed after a hiatus that was inspired by tales of an unlikely rebound in a debt-laden American economy.
Interestingly, what is emerging is some combination of both of the above and that is serious. America could be experiencing an economic slowdown and, at the same time, see its imports surge because of high oil price. Egged on by automobile producers to acquire more (fuel inefficient) vehicles that they do not need, it is possible that the demand for gasoline (petrol) has become less elastic in the US. Consequently, despite a slowing economy, imports might remain high. Thus, potentially high trade deficit unsupported by interest rates presages a significantly weaker dollar. However, the weakness of the dollar will have to fall disproportionately, yet again, on the global major currencies. Asian currencies are unlikely to make gain against the dollar as their economies would be unable to cope with high crude oil price.
The Asian economic miracle, after the 1997-98 Asian crisis, remains a work in progress, notwithstanding tall claims or hopes to the contrary expressed by East Asian governments and their cheerleaders.
Complacency over oil
Generally, there has been breathtaking complacency about the impact of higher crude oil price. Even the Fed, justifying its rate hike last week, blithely expects high energy prices to moderate. Investment banks, relying on demand and supply figures, expect prices to moderate. History is on their side. High price for oil has invariably contributed to its own decline, as demand is elastic, new supply comes on stream at higher prices and oil extraction from rare fields becomes viable. However, there is only so much driving that one can do by looking at the rear-view mirror.
The energy efficiency of the Western economies is often cited as the proof of the resilience of global economy to high oil price. It may be partially true. Previous oil shocks might have pushed back the threshold oil price that hurts global activity. Hence, the impact of a high price for energy would not be linear. But to dismiss it as irrelevant is dangerous folly. Every recession in America has been preceded by a surge in oil price. This year's high crude oil price might already presage one in 2005. Perversely, the Fed is preparing for it now by raising rates so that it could lower them next year!
Optimists who argue for lower prices may be overlooking two factors. One, they assume that the figures on which they base their analyses are reliable and, two, they may be overestimating demand elasticity. It is doubtful if they could really model the emergence of nearly 2.0 billion people out of poverty into lower and middle income classes and the resulting shift in demand curve to the right: More quantity is demanded at all prices.
In India alone, casual observation would record the explosion in the number of automobiles on the road and the chaotic way in which traffic is organised. Both contribute to rising fuel consumption. Further, the policy of subsidising passenger traffic with freight means there is larger movement of goods through roads. This further enhances demand for hydrocarbon fuels.
Faulty OPEC reserves and output data
Despite the OPEC (Organisation of Petroleum Exporting Countries) increasing its output from August, crude oil price has continued to surge unabated. Analysts are forced to conclude based on persistently high price that they might have erred in estimating both demand and supply. In 1987, most OPEC countries increased their estimation of reserves, overnight. That was because production quotas were to be set in line with estimated reserves. Since then, the reserves have stayed constant. That is possible only if new discoveries matched production year after year. That is a statistical impossibility.
Recently, a leading firm of Texas oil consultants backed by British economists pointed to OPEC as the reason behind the current crude oil price surge. They accused the cartel of deliberately exaggerating the real level of its members' output. They calculate that OPEC members have been exaggerating their oil output by up to 2 million barrels per day (bpd), more than 7.5 per cent.
According to the official data, millions of barrels of oil are accumulating in untraceable depots, a possibility that is dismissed as implausible by oil and shipping analysts. This paradox, dubbed the "mystery of the missing barrels", has now been solved, according to new research from Groppe, Long and Littell, a long-established Texas-based oil consultant whose clients have included Shell, ChevronTexaco and BP; and from Lombard Street Research in London.
After analysing 30 years of data, focusing on import figures of all the main oil consumers and adjusting them for the quality, type and weight of oil and different measures used, Groppe and his team have uncovered discrepancies.
On average, the OPEC countries claim to produce between 1.25m bpd and 2m bpd more than their real output. Only half of all announced supply increases actually materialise.
Groppe said: "There is no way to get accurate information on any OPEC country's oil exports. The IEA is forced to rely uncritically on what it is told by governments. The real level of Saudi production is one of the most closely-guarded secrets in the world."
In a bid to hide the fact that they are not producing as much oil as they claim, some OPEC countries are also over-reporting their consumption of oil. Demand for oil from West Asia is officially set to hit 5.56m bpd this year, almost as much as the 6.29m bpd from China. It is allegedly also greater than the 4.82m bpd expected to be consumed by the whole of Latin America this year.
UK is to become a net fuel importer soon
Among non-OPEC producers, the UK trade deficit, which swelled to 4.97 billion pounds ($8.9 billion) in June, is set to widen as North Sea oil reserves that were first tapped in the 1970s become depleted, said Alex Kemp, Britain's official oil historian.
The trade deficit widened in June from 4.8 billion pounds in May, the government said in a report yesterday, as the surplus in oil declined to 22 million pounds, the lowest since August 1991. By volume, Britain imported more oil than it exported in June. The UK, Europe's second-largest economy, may become a net importer of oil and gas within three years, Kemp said.
By the end of 2002, the UK had produced a total of 32.9 billion barrels of oil equivalent, which includes oil and gas, with remaining reserves possibly as low as 13.6 billion barrels, the latest available government figures show.
As early as next year, the UK, the world's fourth largest gas producer, will become a net importer of the fuel, according to forecasts by Kemp and the UK Offshore Operators' Association, an industry lobby group.
The case of Oman and its parallel for Saudi Arabia
The UK has joined Indonesia which, earlier this year, became a net oil importer. An article by Bill Powers, Editor of Canadian Energy View Point (http://www.financialsense.com/editorials/powers/2004/0801.html) argues that some of the enhanced oil recovery techniques employed by Oman have resulted in an accelerated decline in production and that similar techniques Arabia have also been employed on the world's largest oil field, Saudi Arabia's Ghawar. Horizontal drilling in Oman's Yibal field has led to a dramatic increase in water production and an equally impressive decline in oil production.
Matt Simmons, one of the US President, Mr George Bush's energy advisors, believes that Ghawar field is about to head into terminal and irreversible decline. Should that happen, the world would soon experience triple digit oil prices.
He favours pricing crude oil at $182 a barrel so that demand could be controlled and there would be time to find bridge fuels and fuels to fill the gap between an oil economy and a renewable economy (http://news.bbc.co.uk/2/hi/business/3777413.stm). Mr. Matt Simmons also belongs to the Association for the Study of Peak Oil and Gas (www.peakoil.net).
It would be useful to know if India, a heavy oil importer, has any strategic thinking not only to counter short-term price spikes but also a long-term fuel plan for a one billion strong economy. Neither this government nor any in the past has displayed a comprehensive approach to energy security. The previous government merely sanctioned the building up of a strategic oil reserve. That is a short-term remedy.
For now, as Stephen Roach of Morgan Stanley puts it, there is a 40 per cent chance of a global recession in 2005 and rising by the day.
With a marginal current account surplus, a lower fiscal deficit and a higher starting point for cutting interest rates, Europe seems better placed than a debt-laden America and an energy importing Asia, to tackle that. Investors should know where to place their bets.
(The author is an economist based in Singapore. Please address feedback to firstname.lastname@example.org)
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