The oil price: what’s happening, what next?

Herewith an attempt to marshal my thoughts about what’s happening on the oil price (which has fallen sharply over the last few weeks), what’s likely to happen next, and what policymakers need to do to move forward. Brief summary as follows:

– The oil price has fallen sharply over the last couple of weeks, from a peak of $147 to a 7 week low of $123 at close yesterday. So is this the start of a long decline, or just a brief pause to draw breath before a resumption of the relentless upward march of recent years?

– In a nutshell, probably more like the latter – but with the potential for a big drop in the near term for as long as the credit crunch lasts, as emerging economies slow down sharply in line with falling US demand for their exports.

– However, once we’re through the crunch, we may be back to a game of cat and mouse between oil supply and economic growth. Demand falls, oil price falls; demand picks up, oil price goes back up too – but never for long enough to give investors a clear signal to pump cash into new oil supply infrastructure.

– What we need is a game changing intervention that breaks us out of this stop-start cycle. Massive investment in new oil supply would provide it, but can’t be squared with what needs to happen on emissions reductions.

– It looks like the only way through is for policymakers to agree a global climate policy framework that’s both global in scope and sufficiently long term to provide investors with an unequivocal signal of where to put their cash: this is the only way of squaring energy security with climate change.

Full version after the jump.

Start by looking at what’s happening on the demand side for oil. We already know that demand for oil in the US has been slowing sharply for some months now. Motorists are driving less; the bottom’s fallen out of the market for 4x4s. The big question in the background, though, has been what’s happening in emerging economies. In the case of oil as in the case of food, it’s rising demand in China, India and other transforming economies that’s been the mainstay of rising prices. Will that continue, even as the US and other OECD economies slow down sharply?

Fred Bergsten at the Peterson Institute is at the forefront of a clutch of optimists who think that a fundamental change in the global economy has taken place, whereby these emerging economies have effectively ‘decoupled’ from the US. To wit:

The global economy has clearly decoupled from the US and world growth remains close to 4 per cent in spite of the absence of any increases in domestic US demand. Continued expansion abroad, especially in the emerging market economies, has in fact cushioned the slowdown and so far prevented recession in the US. Hence we are also experiencing the first episode in history of reverse coupling, in which the rest of the world pulls the US forward rather than the opposite … In spite of the international transmission of substantial financial as well as real economic shocks from the US, the traditional relationship where “the world catches cold when the US sneezes” no longer holds.

Pretty unequivocal stuff. But for the opposite case, check out Merryn Somerset Webb – the FT’s excellent new Saturday investment correspondent – who has this to say in today’s paper:

It seems that the US – just like the UK where retail sales fell nearly 4 per cent in June – has reached a saturation point. It’s hard to see how matters can improve. With no saving cushions; asset prices falling; and no more scope for mortgage equity withdrawal, consumers have little choice. They can either sell assets (tricky) or they can cut back on spending. They’re also likely to start bumping up their savings soon – after all, if your house isn’t your pension you’re going to have to get a real pension somehow.

And that means that there is trouble ahead for emerging market growth. Chinese export growth is already slowing fast. In June it was just over 17 per cent year on year, down from 28 per cent in May and I’ll bet it falls a lot further – let’s not forget China’s chief export market is imploding (the US consumer still accounts for one-fifth of global demand). I suspect the global recession has only just begun.

Now, I’m no economist, but on this one, my hunch is with Merryn Somerset Webb (and with Nouriel Roubini, who’s been saying all along that the decoupling argument is nonsense). If that’s right, and emerging economies really are poised to run into a serious downturn, then oil prices should indeed start to fall – as Merryn Somerset Webb also forecasts: “Lehman Brothers is forecasting oil prices to be $90 next year. I’d put my bets on seeing that long before we see $200.”

Moreover, even if the new Asian giants did prove to be relatively immune to the US slowdown, there’s still the more basic fact that onging high oil prices will at some stage start triggering ‘demand destruction’ – a point that Dan Yergin was arguing back in May. Merryn notes that:

the International Energy Agency has cut its forecast of global demand growth for 2008 by almost 50 per cent to under 1 per cent (over the last few years it has tended to run at around 1.8 per cent).

She continues that the supply side looks set to ease a little too:

New production is kicking in and, says Niels Jensen of Absolute Return Partners, another 3m barrels a day are forecast to be added to supply by late 2009.

If that’s right, it would be a significant shift: production levels have kept stubbornly to around 85 mb/d over the last few years (a point not lost on those who argue that global oil production is already peaking).

However, Merryn also thinks that “long term it is reasonable to think an uptrend will resume – the US will eventually recover and Asian growth isn’t going away forever”. I think so too, although my reasons are more on the supply side.

For one thing, I don’t believe that OPEC has much spare capacity to give. For another, investment in new production capacity looks may look a risky proposition to many investors – not only because of recent price falls, significant though those are, but also because of the longer term uncertainty over future climate policy. If policymakers are actually serious about limiting warming to two degrees C, then new oil wells aren’t obviously the wisest place to put your cash.

All this poses the question: if oil prices fall during a global slump but then pick up again over the longer term, how long does the interim phase last? Merryn thinks it’ll last “for some time” – probably true, given the credit crunch and the ongoing crisis in financial services. Once we’re through that, though (however long that takes), it becomes anyone’s guess: a slump in the economy would indeed lead to lower fuel prices, but then lower fuel prices ought to lead back to a pick-up in the economy – and bring us right back to where we are now.

What’s really needed here is a game-changing intervention that breaks out of what could become a stop / start cycle on the oil price that never really settles down – instead producing a persistent volatility that makes life miserable for investors, businesses and consumers alike.

One such intervention would be a massive global push for investment in new oil production – of the kind Gordon Brown was hoping for when he went to Jeddah a few weeks back. But there are two big problems with that scenario. One: it’s hard to see it happening in reality, given the problems of investor uncertainty already noted. Two: even if it did, it would be totally at odds with what needs to happen on climate change.

A better way forward would be for policymakers to agree a really comprehensive climate policy framework that actually provides a clear signal on the world’s direction of travel on energy – which would mean eschewing the temptation to follow Kyoto’s expiry in 2012 with an evolutionary approach based on another 5 year ‘commitment period’ – which would be way too short to give energy investors any certainty about anything. 

Instead, policymakers ought to agree a full term framework, with binding commitments that run for decades ahead: all the way, in fact, to the point at which CO2 concentrations are stabilised at a safe level (which policymakers would agree on the basis of scientific advice, making sure that the target could be revised in line with emerging science findings).  To provide long term certainty to investors, the framework would also need to include binding emission caps for all countries, rather than just developed ones.

What this would achieve – apart from the small matter of solving climate change – would be to provide investors in new energy infrastructure with a clear, credible and above all sufficiently long term signal on where to put their cash. It’s not an immediate term solution to provide relief to pissed off voters, true. What is is, though, is the only long term solution that joins up the dots between energy security and climate change. We need to get on with it.