Paradigm-challenged economists: Roubini and the oil market

Professor Roubini has just provided us with a fine piece of economic analysis and policy recommendations at http://www.rgemonitor.com/blog/roubini/230471/ . If only it wasn't so detached from the dynamics of physical reality.

He wrote:

"The central banks current concerns with a rise in inflation are totally misplaced as a US recession will lead to global disinflation (and concerns about deflation as in 2002-2003) via four channels:
d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges. We are set for the repeat of the 2000-2003 cycle ..."

To assess the validity of the statement in item d), let's first look at the current situation and prospects of world crude oil (actually "All liquids", i.e. including biofuels) production and demand as depicted in page 48 of the OECD IEA Nov. 13 monthly report at

World oil total demand (actual and projected):
1Q06 2Q06 3Q06 4Q06 2006 = 85.5 83.5 84.3 85.7 84.7
1Q07 2Q07 3Q07 4Q07 2007 = 85.8 84.7 85.3 87.1 85.7
1Q08 2Q08 3Q08 4Q08 2008 = 88.2 86.5 87.2 88.9 87.7
World oil total production (actual):
1Q06 2Q06 3Q06 4Q06 2006 = 85.4 84.9 85.5 85.3 85.3
1Q07 2Q07 3Q07 4Q07 2007 = 85.4 85.0 85.0

After looking at these numbers, it takes an extraordinary degreee of optimism to expect that production will "surge" in 2008 to meet the currently projected demand. Even when taking at face value the preliminary IEA October production number of 86.43 MBpd, which Stuart Staniford doesn't in his analysis at
http://www.theoildrum.com/node/3306 .

To see what kind of price action can be expected from these projections, I´ll use some material already posted at
http://peaktimeviews.blogspot.com/2007/11/assessing-impact-of-current-oil.html .

Let's compare global demand averages for whole years and their increases:
for 2006: 84.7 mb/d
for 2007: 85.7 mb/d (+1.2%)
for 2008: 87.7 mb/d (+2.3%)
with price action from the past year:
On Nov 20, 2006 WTI = $59 and EUR = $1.28, so WTI = EUR 46.
On Nov 20, 2007 WTI = $98 and EUR = $1.48, so WTI = EUR 66.
That's for a WTI price rise of 66% in dollars and 44% in euros in a year.

Thus, if a 1.2% increase in demand against constant production over Dec 2006 - Nov 2007 caused in 44% increase in price in euros, a 2.3% increase in demand against constant production over Dec 2007 - Nov 2008 can be expected to cause a 44 x 2.3/1.2 = 84% price increase in euros, to a price in Nov 2008 of EUR 121. Assuming EURUSD stays at 1.48, that's $180.

Let's now be optimistic and assume that 2008 production will rise 1.1% over 2007, leading to 2.3 - 1.1 = 1.2% as the differential increase of demand vs production in 2008, which is the same value as for 2007. The expected price increase would thus be a further 44% in euros, to a price of EUR 95 and $140.

And obviously, for the oil price to stay at current levels, the world needs for 2008 both an increase in production over current levels AND a decrease in demand from current projections for a combined total of 2.3%. I.e., if demand does rise 2.3% as currently expected, so should production, which looks extremely unlikely.

Therefore, for the oil price to remain in the current range, even optimistic projections for oil production lead to the need of at least a deceleration in global economic growth from current projections. And given the ease and gusto with which OPEC and Russia would cut production levels should a fall in demand take place out of a hypothetical deep recession, it's very unlikely that, even in that case, the oil price would drop substantially.

Now let's take a closer look at where the increases in demand came or are expected to come from, in order to evaluate then the likelihood that they could be prevented or even reversed by way of a hypothetical recession. From page 50 of the OECD IEA Nov. 13 monthly report, annual changes in Mbpd were/are projected to be for the key players:

Player 2005 2006 2007 2008
N.Am. 0.12 -0.21 0.21 0.22
Euro. 0.12 0.01 -0.25 0.21
APac 0.07 -0.16 -0.05 0.18
OECD 0.32 -0.36 -0.09 0.61
FmrSU 0.06 0.18 -0.18 0.14
China 0.27 0.46 0.39 0.42
Ot.Asia 0.17 0.07 0.26 0.19
LatAm 0.14 0.18 0.20 0.16
MEast 0.26 0.29 0.30 0.29
World 1.41 0.84 1.01 1.94

It's evident that the main culprit in the projected jump in demand for 2008 is the OECD, followed by the reversal of the 2007 FSU demand contraction, which the report itself describes as "an outcome that goes against the trend of strong economic growth, but could also reflect efficiency improvements or data quality issues." And within the OECD, the problem is that demand in Europe and Asia Pacific will switch to growth while US demand is staying its growth course.

Thinking now the other way round, if a reduction in global demand growth must be achieved, what are the likely candidates for it? Obviously the OECD, with a recession arising from the unfolding financial crisis. So we have a match here.

And it is easy to see that, even if that OECD recession materializes, the other players are extremely unlikely to reduce their oil demand. The reason for that being:

- For non-oil exporters like China and East Asian countries, the huge foreign exchange reserves that these players have accumulated over the last years, which make their situation entirely different from that in 2000-2003: having already saved for a rainy day (or rather decade), they can now afford to keep growing their internal consumption even if half of their customers curtail the demand for their products.

- For oil exporters like the FSU, ME and several LatAm countries, the fact that it is just not reasonable to expect they would refrain from growing the consumption of their own product.

To sum up, a prompt OECD recession is the only way to avoid triple digit oil prices in 2008 and will most probably result in oil prices staying in the current range. (This of course does NOT mean that such a recession is the long-term solution to the energy problem. It just provides a window of opportunity for addressing the problem in a decisive yet orderly way.)

As for food, the possibility of a fall in prices is even more remote. In the first place for its low elasticity of demand. Secondly because, with a reasoning analogous as that for oil, it is not reasonable to expect that countries that have amassed huge forex reserves or oil exporters would hesitate to draw from their reserves/revenues and skimp on food. Not to speak of food exporters. And thirdly because, with oil prices staying in the current range, the worldwide implementation of biodiesel production will most likely proceed, keeping the pressure on food prices.

Now, are there any other potential benefits from an OECD recession apart from preventing disruptively high oil prices and a likely consequent collapse in the dollar value and the loss of its role as the international trade and reserve currency? Yes, there are a couple of them, and probably of even greater importance.

1. As shown in the previous post
http://peaktimeviews.blogspot.com/2007/12/even-bigger-risk-for-2008.html , allowing demand to follow the current growth path poses a significant risk of shortages in some finished products, likely followed by hoarding behaviour by users, which in turn creates a "run on the petroleum bank."

2. Although a recession would certainly curtail demand for electric cars, energy-efficient houses and solar panels, a cursory look at the real world should be enough to notice that the current profile of aggregate demand includes, in a scale ORDERS OF MAGNITUDE greater than those above, things which not only waste fossil fuels but also leave society in a state of ever greater vulnerability to the unavoidable coming energy decline, suburban and exurban construction being the most conspicuous example, followed by production of inefficient vehicles, precisely the two items whose construction/production would be most affected by a recession. So we have another match here.

And I will end with this paragraph from my previous post, which seems all the more relevant in view of proposals like Professor Roubini's.

There are a few big mountains in the world where you can drive to the very top. Those who have done that know quite well that it would be very unsafe to drive on the way down in the same way as on the way up. They make a driving paradigm change when they start the descent. In contrast, today's economists are severely paradigm-challenged. They have known nothing but the way up (to Hubbert's Peak), and they don't seem to be able to make the mental adjustment to the way down. As a result, their driving paradigms are becoming unsafe.

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