Editor’s note: Over the last several weeks, Dr. Duarte and Jim Puplava, host of the Financial Sense News Hour have been discussing the possibility that the global economy has finally begun to feel the effects of prolonged high oil prices. In this analysis, originally penned on June 6, 2006, Dr. Duarte looks at former Fed Chairman Alan Greenspan’s take on the relationship between high oil prices and the global economy, and looks at the potential repercussions. The June 10, 2006 show goes into great detail about this topic  Also see Dr. Duarte’s Peak Oil series.

Greenspan's Warning Could Coincide With A Top In Oil
Former Fed Chief Still Packs Wallop

Are the conditions ripe for a top in the oil markets? The combination of full tilt production from OPEC and non-OPEC sources, a potential softening between Ira and the U.S., decreasing demand, rising interest rates and the death of a terrorist leader could be a signal that a significant correction is coming in the oil markets.

Alan Greenspan showed the markets, and Congress that he can still make things happen, and that he is an excellent market timer, as the former Fed Chief's comments before Congress on June 7, seem to have planted a seed of fear in the minds of traders, and might influence the next move from the Federal Reserve. Greenspan's warning came at a crucial time, as global central banks, including the Federal Reserve seem to be on a longer than expected campaign to raise interest rates. The latest example was an overnight and surprising increase in interest rates from Korea's central bank, while traders are fully expecting Europe's central bank to join in the rate hike fest.

According to Reuters: "Former Federal Reserve Chairman Alan Greenspan on Wednesday offered a grim view of the world's rising vulnerability to high crude oil prices, saying he was skeptical that oil producers can pump enough crude to meet future demand. Since the 1940s, U.S. consumers have shown an uncanny ability to shoulder rising energy prices, but consumers' immunity to oil price shocks is running out, Greenspan said."

The Wall Street Journal reported: "Sharply higher oil prices have yet to seriously erode global economic activity, but recent data indicate the U.S. "may finally be experiencing some impact," former Federal Reserve Chairman Alan Greenspan told the Senate Foreign Relations Committee on Wednesday."

According to the Journal: "Mr. Greenspan said the U.S. was able to withstand the high oil prices over the past year because of a flexible economy as a result of deregulation," but warned that ' "growing protectionism" could undermine flexibility and make the U.S. more vulnerable to swings in the oil market. Mr. Greenspan suggested that high oil prices may be here to stay given low investment in new production by oil-producing nations and their state-owned companies. Unless those policies change, "it is difficult to envision a rate of re-investment by these economies adequate to meet" demand, he said.'

Indeed, it was Mr. Greenspan, who in prior testimony before Congress, popularized the notion that every major slowing in the U.S. economy during modern times has been preceded by a bout of higher oil prices.

OPEC: Concerns About Oil Glut

Two OPEC ministers have shown concerns about rising oil stocks in the last few days.

According to Dow Jones Newswires, on 6-7-06: ["The UAE's oil minister said Wednesday he and fellow Organization of Petroleum Exporting Countries members are concerned that oil stocks are rising too rapidly. In an interview with Dow Jones Newswires, Mohamed Bin Dhaen Al Hamli said: "We are witnessing an increase in crude oil stocks and this is of concern to us. But we understand what consumers are doing (building oil in inventories) because global production capacity is so small, they are storing oil." ]

Dow Jones newswires added: "Hamli's comments closely follow news that OPEC's de facto leader Saudi Arabia has been cutting back its crude volumes. Saudi Oil Minister Ali Naimi, in an interview with The Wall Street Journal published Monday, said the country's output in April averaged 9.1 million b/d, its lowest level since January 2005. Global oil prices have risen 10% from a first-quarter average of $65 a barrel to remain above $70/bbl since the kingdom's cut was implemented. Naimi, speaking after OPEC's Caracas meeting, said the reduction was in response to a decline in demand, not an attempt to limit supply and keep prices at current high levels. Hamli also spoke of his concern that high oil prices may start to have a negative impact on the global economy."

Market And Geopolitical Implications

Global markets churned overnight as the potential for a changing scenario seems to have finally hit traders.

Aside from rising interest rates, the markets are now coming to grips with the fact that significant excesses have been built into price expectations based on excess liquidity, which global central banks are suddenly increasingly serious about removing from the global economy.

If prior scenarios are a guide to the future, then those economies most dependent on liquidity, such as China, Japan, and other export dependent countries are going to feel the pinch.

If the global economy is indeed about to slide into some kind of retrenchment, then the next set of countries to get hit will be the oil producers.

From a geopolitical standpoint, the three most vulnerable oil based economies are Russia, Iran, and Venezuela.

Each of these three producers has been increasing the use of oil and natural gas, in the case of Russia, as a political weapon.

If petroleum and energy prices collapse, this triumverate will lose a significant amount of the clout that it has gained over the last few years.

Conclusion

Mr. Greenspan might have had yet another "irrational exuberance" moment.

Although there was no buzzword or prime time sound byte, the message was clear: "recent data indicate we may finally be experiencing some impact."

In other words, if Mr. Greenspan is correct, and we believe that he is, the price of oil has risen to the point where several key events have occurred:

1. Consumers have started to change their driving and consumption habits.

2. Producers have started to believe that prices above $70 per barrel will never fall.

3. Political agendas with long term objectives have been crafted based on expectations of oil prices that would never retreat.

4. Global economies have begun to suffer from the effects of persistently high oil prices.

When everyone agrees that this time is different, it usually means that a major inflection is at hand.

This seems to be one of those times. As with any other set of predictions and indications, though, a major terrorist attack, an uptick in the weather, or any number of potential surprises, could be enough to derail the scenario.

© 2006 Joe Duarte, M.D.
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