Stephen Leeb Sees a Grimmer Horizon
I just finished reading Stephen Leeb’s new book “The Coming Economic Collapse - How You Can Thrive When Oil Costs $200 a Barrel.” I was curious as to why Leeb’s new book had a grimmer sounding title. His previous book,” The Oil Factor,” was about a coming energy crisis, but seemed more optimistic in its outcome. Reading the author’s note I soon leaned why. “Oil Factor”, was primarily an investment book, a book written with ideas on how to make money in energy. Leeb felt at that time that higher energy prices would force the government and the markets to take action and begin a crash program to develop alternative energies as peak oil approached.
Nothing has happened despite energy prices that have come close to Leeb’s prediction of $100 oil. The new book treats the coming energy crisis more seriously. In the author's words, the energy crisis is becoming a “civilization-threatening crisis.” Leeb is dismayed at the lack of attention from Harvard professors, Wall Street analysts, government officials and oil company executives to the approaching energy crisis.
Leeb cites two recent books by Jared Diamond, “Collapse” and Joseph Tainter, “The Collapse of Complex Societies" that our world was falling prey to a colossal set of misjudgments. “The Coming Economic Collapse” is the author’s best attempt to convince readers that this crisis is real and unless addressed immediately it could lead to economic collapse and threaten civilization itself.
As always Leeb’s thoughts are prescient and thought-provoking. This is definitely a book worth reading. Stephen Leeb will be a guest on my radio show March 10th.
World Oil Production has Peaked
Last year two of the major oil fields (Cantarell/Mexico & Burgan/ Kuwait) in the world reported that their oil production had peaked. Early February of this year the WSJ reported that because of encroaching water and gas at Cantarell, Mexico’s biggest oilfield, output could drop precipitously over the next few years. Up until recently Cantarell had been producing two million barrels a day. Under different Pemex scenarios production could drop to 875,000 barrels a day in 2007 and to 520,000 barrels by 2008. The drop in output at Mexico’s largest oilfield would be bad news for the United States. Mexico is the number two source of oil, behind Canada for the U.S.
Cantarell and Burgan aren’t the only oilfields that have peaked and are declining in production.
As noted above, Ghawar and China’s DaQing have also gone into decline.
As if the oil markets needed more bad news, Iraqi oil output has also gone into decline. Before the U.S. invasion in March 2003, Iraq produced 2.5 million barrels a day. Output fell after the war, but eventually increased back to 1.8 million barrels throughout most of 2004 and 2005. Because of recent terrorist’s attacks on Iraq’s oil infrastructure, production dropped to 1.66 million barrels a day in the final quarter of 2005. As late as January of this year oil output fell again to only 1.5 million barrels a day. Moreover, output at individual wells has been dropping over time requiring Iraq’s engineers to constantly drill new wells or stimulate older ones. Geologists believe this reflects the wells' natural decline rates. The problem is that declining output is not being offset by new investment and drilling. Presently, production is down by 500,000 barrels a day.
Last weekend rebels in Nigeria kidnapped five more Shell oil workers. The company has taken evasive action by shutting down its operations in the west end of the delta. The result is that 450,000 barrels per day of production has been taken offline. This represents one-fifth of Nigeria’s output.
The combination of Iraq’s fall in output, the decline in Kuwait, and the reduction in Nigeria’s production means well over 1,000,000 barrels of daily production have been taken offline. In a world where OPEC spare capacity is only around 1.5 million barrels is it any wonder why oil prices remain stubbornly high? Today over 20% of U.S. oil and gas production in the Gulf remains offline.
An Ominous Trend
Last week on my radio show I discussed Carol J. Loomis’ article in the recent issue of Fortune about the growing possibility of GM’s bankruptcy. Listed below is a look at the company’s deteriorating debt ratios.
What makes this story more remarkable is that GM has $119 billion set aside for pension and medical liabilities. This $119 billion stands in sharp contrast to GM’s market cap, which is less than $12 billion! Employees and unions have $119 billion versus shareholders equity of $11.96 billion. Who owns the company—the shareholders or the union?
Oil Props Up the Dollar
Wall Street is still optimistic that the U.S. dollar will remain strong propped up by rising interest rates. But there is something else that is also helping to prop up the buck. That "something" is higher oil prices. Since oil is priced in dollars, higher oil prices require more dollars to buy oil. It is the threat of pricing oil in euros that poses the greatest risk to the dollar longer-term. While higher interest rates in the U.S. may make the dollar more attractive, the fact that oil is denominated in dollars also helps to support the dollar. Remove the prop of petrodollar pricing and higher interest rates and the dollar is toast—something to think about, if you’re a dollar bull.
This Hasn't Been an Ordinary Economic Cycle
The Present Consensus
Most analysts and investors think that the U.S. is experiencing a typical economic cycle. As economic growth accelerated and the risk of inflation rose, the Fed stepped on the breaks in order to slow down the economy. This is what the Fed has always done for the last half century. The economy heats up, the Fed comes in and raises interest rates to cool the economy down. Eventually the economy heads into a recession, the Fed responds by lowering interest rates, the economy recovers, and the cycle begins anew. This cycle has been repeated so many times that it is now taken for granted. Therefore as the economy slows down, the Fed will go to neutral. As the economy weakens, the Fed may revert to slashing interest rates in order to re-stimulate economic growth. The slowing economy should take pressure off inflation and a period of disinflation should set in. This will allow the financial markets to respond and recover and interest rates to fall.
My Thoughts
This hasn’t been an ordinary economic cycle or a normal Fed rate-raising cycle. Many aspects of the financial markets have turned out differently—beginning with the last recession. As the recession hit in 2001 and the events of 9-11 took place, the economy reacted differently than in the past. Instead of pulling in the reins, paying down debt and increasing savings, the consumer did just the opposite. Consumers went on a debt and spending spree. Instead of declining ahead of a recession, real estate prices rose. Consumers responded to lower interest rates by buying new cars, bigger homes, new furniture and home entertainment centers and went on vacations—all financed by debt. The recession in 2001 was a business-led recession. The consumer never retrenched. Real consumer spending and residential investment accounted for more than 80% of real GDP over the last three years.
The financial markets also reacted differently. Long-term interest rates fell instead of rising with Fed rate hikes (the conundrum). Inflation rates rose and interest rates declined. Tuesday of this week was a good example. The government reported a big jump in CPI by 0.7% last month. The bond market rallied on the news supposedly because the “core” rate (that doesn’t apply to anybody) climbed only 0.2%.
In addition to falling interest rates with rising inflation rates, energy prices soared, and yet the economy grew. Despite record trade deficits and budget deficits the dollar held firm and actually appreciated against major currencies. As the dollar gold was its faithful companion. Gold not only rose with the dollar, it also rose against major world currencies.
To say things are different this time would be oversimplification. This time it really is different! It will also be different when the Fed goes on pause. Declining commodity prices between 1980 and 2000 gave the Fed the wherewithal to inflate without suffering the consequences. Money growth as shown in the graph below grew at twice the rate of economic growth. However, note the precipitous drop in commodity prices as shown in the CRB Index below. The index dropped from a high of 335 in November 1980 to a low of 182 in January of 1999. The drop in commodity prices was the tailwind just as the higher commodity prices of today could become a headwind leading to higher inflation rates. The US was also lucky. As the world’s reserve currency, it could run massive trade and budget deficits and pay for its bills in its own currency. The ability to import more of its domestic goods from Asia further kept a check on prices as excess money and credit were channeled into lower-priced, foreign-made goods. The only real inflation was experienced in the financial markets were excess money inflated stock and bond prices.
Climbing the Mountain
For most Americans borrow and spend has become a way of life made possible by decades of declining interest rates and rising asset prices. The '80s and '90s bull market in stocks, followed by a bull market in real estate, prompted Americans to forget their savings accounts. Most Americans have seen their assets appreciate—whether the family castle or the stock portfolio. All of this abundance (asset appreciation) and low cost borrowing was made possible by a loose monetary policy carried out by the Greenspan Fed. As alluded to above, inflation primarily worked its way through the financial markets inflating assets along the way. The combination of a bear market in commodities and cheap imports from Asia has kept consumer prices moderate as measured by the BLS. I would submit that over the last five years most Americans have experienced above-average trends in their cost of living—core rate notwithstanding. The Fed seemed to be able to work its monetary magic as it inflated and expanded credit without suffering the inflationary consequences of its actions.
I believe that we are now at an inflexion point. Things won’t be as easy in the future. Decades of inflating are now about to play catch up. Review the two charts below, which show the 10-year t-note and CRB index. Note as commodity prices inflated in the late '60s, the parallel course in rising interest rates. Conversely, when commodity prices fell throughout the '80s and '90s, interest rates came down as well. This period was a period of disinflation.
Since bottoming in 2001, commodity prices have moved up relentlessly and there appears to be little sign of reversing course. While commodity prices have soared, long-term interest rates have consolidated and virtually gone nowhere. Rates have been kept artificially low as a result of central bank intervention, the carry-trade, and the relentless pursuit for yields in a yield-starved environment. Everyone is waiting for the Fed to end its rate-raising cycle. They believe that when it does, long-term rates will recede. Don’t bet on it.
This hasn’t been a normal rate-raising cycle. If what I suspect is correct, we are about to embark on another journey up that mountain. It may be quick. . . it may be slow. No one knows at this point. However, I believe it's time to get out your rock climbing equipment again. Rising inflation is going to find a companion in rising interest rates.
Until the next time... fair winds and clear skies!
© 2006 James J. Puplava
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