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Peak Oil, the Saudis and the Middle East protests

One serious addendum I made to my 2011 outlook had to do with oil and commodity prices. While I am cautiously optimistic, there are a number of potential pitfalls to a rosy scenario. Here’s what I said about oil and commodities:

Commodity price Inflation: There is a real threat to recovery from commodity price inflation. We have already begun to see signs of food price riots, food price controls and the like in emerging markets. Additionally, Brent crude is at 27-month highs, closing in on $100 a barrel. Just think back to 2008; this type of commodity price inflation was toxic and sowed the seeds of its on demand destruction.

I made the case multiple times in November that food price inflation was going to be a problem despite sanguine views from analysts like those at Morgan Stanley, saying it should be a policy consideration for the developed economies.

The rise in food and energy prices should be taken into consideration by government officials conducting pro-inflationary policies. What should be of concern regarding commodity price inflation is how it represents a regressive tax on lower income workers and consumers in emerging markets and developing countries. Lower income consumers spend a much greater percentage of income on food and energy. So when commodity prices increase, it has a disproportionate effect on them.  One reason we saw food riots in emerging markets in 2008 has much to do with this.

However, as I write this, Ben Bernanke is saying that gasoline price increases are entirely due to emerging market demand and constrained supply. Commodities are not affected by the Fed, he says. Fed policy has no role in this. So, you can expect more defenses from the Fed Chairman of this sort even if we see higher commodity prices. His riposte would be that countries like China need to adjust policy since they are the ‘swing consumer.’ Commodities are all about China and their currency manipulation. Brazil, which initially started the talk about currency wars, had been pointing the finger at the U.S.. Now, with Dilma Rousseff in office,  Brazil is more wary of China as Chinese money and goods flood into the country. These themes are very much central to the currency wars and will resurface.

Even resource producers like Saudi Arabia are feeling the pain. And given the riots across the Middle East, this is a concern. The Saudi connection is actually central to this story.

Yesterday, the Guardian revealed U.S. diplomats’ concerns that Saudi Arabia, the swing producer in the OPEC cartel, was overestimating its oil reserves by as much as 40% – that’s four- zero.

The US fears that Saudi Arabia, the world’s largest crude oil exporter, may not have enough reserves to prevent oil prices escalating, confidential cables from its embassy in Riyadh show.

The cables, released by WikiLeaks, urge Washington to take seriously a warning from a senior Saudi government oil executive that the kingdom’s crude oil reserves may have been overstated by as much as 300bn barrels – nearly 40%.

The revelation comes as the oil price has soared in recent weeks to more than $100 a barrel on global demand and tensions in the Middle East. Many analysts expect that the Saudis and their Opec cartel partners would pump more oil if rising prices threatened to choke off demand.

But can the Saudis do it? I pointed to the Saudis tangentially in the sentence on a post about Chinese Hydropower and commodity prices, saying

"oil price spikes have been associated with every major economic downturn since the end of Bretton Woods forty years ago. It sounds like the Saudis are concerned about the negative implications of $100 oil. But, will they be able to do anything about it?"

And no other nation in the world has any spare capacity in an upswing. So, if the Saudi’s can’t get it done, oil will march higher until demand destruction takes over.

Conspiracy theorists will love this one! But, we don’t need a conspiracy theory to see that the end of cheap oil is upon us. To find high quality oil deposits (I am not talking about Oil Sands in Alberta here) is becoming more and more expensive. And one oil field after another is hitting peak. We have seen it in Mexico, Russia, the North Sea, the Alaskan North Slope and elsewhere.  The only thing keeping us from realizing the peak is Saudi Arabia, the swing producer in OPEC.

-Evidence that governments are underplaying peak oil, 10 Nov 2009

Let me recount my story on peak oil from 2008 when oil was peaking. Here was the situation as I saw it in 2008.

In all likelihood, we have temporarily arrived at a point of world peak oil. This means that prices will spiral higher until demand comes to heel. Demand destruction is a negative for economic growth, meaning the world does face a global recession in the face of limited oil capacity. However, this peak may only be temporary. As prices go higher, the ability to use new fossil fuel sources in deep water or via shale oil, oil sands or clean coal becomes economic.

I reckon we will not be able to exploit these additional resources before demand destruction occurs. Therefore, a global recession is definitely in the cards. Once, demand is destroyed, we can start the cycle all over again until we hit a new plateau at an even higher oil price where demand will be destroyed again, setting off the cycle again.

This is a picture of higher highs and higher lows due to demand constraints but also of extreme volatility and whipsawing du to the speculation that such a market is bound to attract.

What about the downside?

The Armageddon scenario
The problem here, of course, is that the world is very dependent on oil. And, there is no guarantee that the excess capacity actually exists.

There has been a lot of speculation of late regarding oil field production capacities declining. In particular, there are great worries regarding Russian and Saudi production capacities. The available data on Saudi production is especially opaque. Matthew Simmons, an expert oil investment banker, has written a book questioning the data the Saudis have provided regarding the proven reserves available for production and the production capacity of the Saudis major fields including Super Giant Ghawar, the largest oil field in the world. I recommend anyone interested in this debate read his book, “Twilight in the Desert.”

This leads us to the Armageddon Scenario. Nuclear-armed nations like China, Russia, India and the United States are desperate to keep their standard of living up. As a result, with oil supplies dwindling, competition for oil supplies will increase. The risk of armed conflict to procure necessary supply increases as peak oil becomes apparent. The U.S. has invaded Iraq, has troops stationed in Saudi Arabia and is threatening Iran, all because of oil — and in Iran’s case, the possibility of another nuclear-armed nation entering the strategic quest for oil. This is a battle of extreme importance strategically for a number of countries. They may stop at nothing to achieve their ends should peak oil become a problem.

Solution
The obvious solution is for nations to recognize that we are at a critical juncture in world history and that the time is now to break dependency on fossil fuels. Conservation is certainly part of the solution. But, alternatives in geothermal, wind, solar, tidal, and nuclear do exist as well. I am optimistic that we will find a technological solution to our problems and that we can continue to grow. But, the time to act is now.

When I say, "act now" I mean make preparations that will take years to come online. In the near term, supply at a given price is fixed. That’s the reason we are seeing so much deep-water drilling. Prices will have to go a lot higher to spur recovery of more expensive oil, involving the attendant environmental risk.

Bottom line: All of the factors I mentioned are driving oil pries higher: supply constraints, greater demand, speculation in alternative investments like commodities, civil unrest in the Middle East. Here’s the thing though, when supply and demand are fundamentally in balance and supply is constrained but demand is inelastic and rising, you have the makings of a parabolic move higher – one that results in inflation, civil unrest, recession, demand destruction and potentially armed conflict. To me, it’s irrelevant what the principal initial cause of the parabolic move is (and a move from under $40 a barrel to over $100 a barrel within two years is certainly parabolic). What matters is what can be done, near-term, to relieve the pressure on prices.

On that score, speculation is of a lesser concern because it only feeds speculative demand as a bubble has become entrenched for fundamental reasons. Monetary policy is of a greater concern because it feeds both fundamental demand and speculative demand due to its effect on the economy. I don’t expect any monetary policy maker to address this – not in China, the U.S., Brazil or elsewhere. As part of the currency wars, it will be all finger-pointing and blame deflection until and after demand destruction sets in. I am most concerned, however, with the fundamental imbalance. If the Saudis are not able to increase supply cost-effectively, we get higher oil prices, high commodity prices, more inflation, more civil unrest and the makings of demand destruction and recession.

How do you play this as an investor? Short-term, you have to get exposure to a scenario that benefits from a gapping up in commodity prices. Short-term, you also need to be protected from the downside in the form of inflation. But, medium-term, you will want protection against recession and debt deflation.

The wildcard is Saudi Arabia, both in terms of potential supply constraints and civil unrest.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

6 Comments

  1. Rob says:

    It’s important to seprate the “peak” oil concept from “easily recoverable” oil (the article sort of alludes to this). I believe the offshore discoveries in Brazil and the untapped oil potential in Iraq is sufficient to make up for the Saudi’s declining production (both potentials were recently revised up). The problem is that the extraction costs in Brazil will make that oil considerably more expensive to produce and the political situation in Iraq will stymie development for a long time. In the medium term (and maybe even longer) we’ll get the oil we need but as the article stated – it won’t come cheap… or fast. In the long term the U.S. will also have no choice but to explore offshore areas in the Atlantic and Pacific coasts which have been off limits for years. It’s just a matter of time.

    • I think I covered that here:

      ” In all likelihood, we have temporarily arrived at a point of world peak oil. This means that prices will spiral higher until demand comes to heel. Demand destruction is a negative for economic growth, meaning the world does face a global recession in the face of limited oil capacity. However, this peak may only be temporary. As prices go higher, the ability to use new fossil fuel sources in deep water or via shale oil, oil sands or clean coal becomes economic.”

      • Anonymous says:

        Yes but oil sands are extremely expensive to separate out. There may be billions of barrels but it will cost a fortune to get out. It might require stable oil prices over $150 to make it economic. Though I suspect that the Saudi oil reserves are much lower than reported. Once they run out then the world economy will be in trouble. The US in particular would go in a serious depression. Its economy is dependant on cheap oil.

    • Also note the following comment which dovetails with yours:

      ” When I say, “act now” I mean make preparations that will take years to come online. In the near term, supply at a given price is fixed. That’s the reason we are seeing so much deep-water drilling. Prices will have to go a lot higher to spur recovery of more expensive oil, involving the attendant environmental risk.”

      • Positroll says:

        Nobody’s wasting as much energy as the US.
        Simple (but not “easy”) solution: 1) Europe style gas tax. 2) VAT

        1) Gas tax
        Introduced in hikes of 5 cents/year, hikes continuing until the gas tax reaches a certain percentage of the oil price. .
        Use the proceeds to pay for
        - writing a check to all car-owners (reducing the social impact of the tax
        (necessary esp wrt rural areas) and stimulating the economy)
        - repair the bridges on the interstate system
        - build high speed rail (esp California and the East Coast).
        - modernize and electrify 5 east-west rail roads for transport of goods (nationalize if necessary)
        - improve local transit where possible
        If everybody knows that gas prices will keep rising, they will start making preparations now. Low hanging fruit first, more expensive stuff later …

        2) VAT
        - reduces waste
        - replaces all national, state and local sales taxes
        - pays for funding of social security + increased benefits for the elderly

        At first glance VAT will seem to bring GDP down, but: money is moved from buying cheep Chinese stuff to providing jobs regarding care for the eldery.
        Same with gas tax: less fuel consumption means money doesn’t move to Saudi Arabia or Chavez’ Venezuela but is used to create jobs in the US.

        Will it happen? Not without a huge crisis, I’m afraid …

  2. Rob says:

    It’s important to seprate the “peak” oil concept from “easily recoverable” oil (the article sort of alludes to this). I believe the offshore discoveries in Brazil and the untapped oil potential in Iraq is sufficient to make up for the Saudi’s declining production (both potentials were recently revised up). The problem is that the extraction costs in Brazil will make that oil considerably more expensive to produce and the political situation in Iraq will stymie development for a long time. In the medium term (and maybe even longer) we’ll get the oil we need but as the article stated – it won’t come cheap… or fast. In the long term the U.S. will also have no choice but to explore offshore areas in the Atlantic and Pacific coasts which have been off limits for years. It’s just a matter of time.

    • I think I covered that here:

      ” In all likelihood, we have temporarily arrived at a point of world peak oil. This means that prices will spiral higher until demand comes to heel. Demand destruction is a negative for economic growth, meaning the world does face a global recession in the face of limited oil capacity. However, this peak may only be temporary. As prices go higher, the ability to use new fossil fuel sources in deep water or via shale oil, oil sands or clean coal becomes economic.”

      • DavidLazarusUK says:

        Yes but oil sands are extremely expensive to separate out. There may be billions of barrels but it will cost a fortune to get out. It might require stable oil prices over $150 to make it economic. Though I suspect that the Saudi oil reserves are much lower than reported. Once they run out then the world economy will be in trouble. The US in particular would go in a serious depression. Its economy is dependant on cheap oil.

    • Also note the following comment which dovetails with yours:

      ” When I say, “act now” I mean make preparations that will take years to come online. In the near term, supply at a given price is fixed. That’s the reason we are seeing so much deep-water drilling. Prices will have to go a lot higher to spur recovery of more expensive oil, involving the attendant environmental risk.”

      • Positroll says:

        Nobody’s wasting as much energy as the US.
        Simple (but not “easy”) solution: 1) Europe style gas tax. 2) VAT

        1) Gas tax
        Introduced in hikes of 5 cents/year, hikes continuing until the gas tax reaches a certain percentage of the oil price. .
        Use the proceeds to pay for
        - writing a check to all car-owners (reducing the social impact of the tax
        (necessary esp wrt rural areas) and stimulating the economy)
        - repair the bridges on the interstate system
        - build high speed rail (esp California and the East Coast).
        - modernize and electrify 5 east-west rail roads for transport of goods (nationalize if necessary)
        - improve local transit where possible
        If everybody knows that gas prices will keep rising, they will start making preparations now. Low hanging fruit first, more expensive stuff later …

        2) VAT
        - reduces waste
        - replaces all national, state and local sales taxes
        - pays for funding of social security + increased benefits for the elderly

        At first glance VAT will seem to bring GDP down, but: money is moved from buying cheep Chinese stuff to providing jobs regarding care for the eldery.
        Same with gas tax: less fuel consumption means money doesn’t move to Saudi Arabia or Chavez’ Venezuela but is used to create jobs in the US.

        Will it happen? Not without a huge crisis, I’m afraid …

      • Positroll says:

        Nobody’s wasting as much energy as the US.
        Simple (but not “easy”) solution: 1) Europe style gas tax. 2) VAT

        1) Gas tax
        Introduced in hikes of 5 cents/year, hikes continuing until the gas tax reaches a certain percentage of the oil price. .
        Use the proceeds to pay for
        - writing a check to all car-owners (reducing the social impact of the tax
        (necessary esp wrt rural areas) and stimulating the economy)
        - repair the bridges on the interstate system
        - build high speed rail (esp California and the East Coast).
        - modernize and electrify 5 east-west rail roads for transport of goods (nationalize if necessary)
        - improve local transit where possible
        If everybody knows that gas prices will keep rising, they will start making preparations now. Low hanging fruit first, more expensive stuff later …

        2) VAT
        - reduces waste
        - replaces all national, state and local sales taxes
        - pays for funding of social security + increased benefits for the elderly

        At first glance VAT will seem to bring GDP down, but: money is moved from buying cheep Chinese stuff to providing jobs regarding care for the eldery.
        Same with gas tax: less fuel consumption means money doesn’t move to Saudi Arabia or Chavez’ Venezuela but is used to create jobs in the US.

        Will it happen? Not without a huge crisis, I’m afraid …