Resources continue to make all the headlines. Only now the question is how low can prices fall?
Take the two lead stories on the News Ltd business web page: “BHP to slash resources output” and “Oil ‘could slump to US$25.‘”
It’s an interesting proposition. And it further highlights why Western economies will not suffer from deflation. Sure, prices for some things may be falling – such as oil and petrol. But will that filter through to other areas of the economy?
We’ve spent the last four years ridiculing central bankers for discounting fuel and food costs from their inflation models, so we aren’t about to discount fuel when it is falling.
With the new policies of ‘super-easy’ credit from the RBA, the Fed, ECB and Bank of England, the main concern remains inflation.
When the bankers and economists talk just of prices when they consider inflation they are only looking at half of the picture. Their argument goes that because the economy is slowing, business and consumers will spend less money. Thus prices will fall, and that could lead to deflation.
Their solution is to set interest rates as low as possible. They are backing that up by issuing as many bonds as possible to soak up excess capital. This is excess capital that the banks don’t want to lend to anyone apart from the government.
Governments are then going out and, erm, lending the cash to the sort of companies – other banks, auto manufacturers, etc. – that the banks wouldn’t dream of lending money to.
Once that source of cash dries up – and it must soon in the US based on bond prices and yields – the only other option left open is to print more money and spend it. Some of it may be for worthwhile projects. But the key is that as worthy as the projects may be, it is simply increasing the supply of money in the economy, which as anyone can tell you, is inflationary.
Yet, this is being overlooked in favour of spreading the false fear of deflation. Why? Simple, a government that spends money is seen to be doing something. Telling the public and business that the best course of action is to let events work things out for itself would never be palatable – people may start asking why the politicians are there in the first place.
It’s the Oil Supply Not the Demand That Matters
But back to the oil and resources story. Oil is a strange beast. The price of crude oil climbed over USD$100 a barrel between 2003 and 2008, until it reached a peak of nearly USD$150.
During that time production and demand increased, setting off fears of global shortages. Of course, the price was also influenced by other issues such as terrorists and hurricanes. And most of all by China.
Today, recession is in the air and now all the talk is of slowing demand and OPEC production cuts.
Analysts from Merrill Lynch now believe the price of crude could dip “all the way to USD$25 a barrel.” But remember, most of the analysts on Wall Street and elsewhere were not convinced that oil prices would rise in the first place. They were constantly playing ‘catch-up’ with their analysis.
As the price ratcheted up ever higher they would call the top and then suggest prices would stabilize. Now the price is falling and they show their true thoughts.
Trying to pick the future price of any asset is hard. Even harder for something as volatile as oil. Despite the likelihood of a global slowdown, it is arguable whether it will necessarily be reflected with a big drop in demand for crude.
You only have to take a look at the traffic on the roads in the last few weeks. There is little doubt that more and more people have ditched public transport and fired up the cars again.
The main influence is not so much the demand – which most of the mainstream seems to be concentrating on – but the supply. OPEC is terrible at trying to control production levels from member states.
As we mentioned recently, there is the constant struggle between supporting a higher price and producing as much as possible to take advantage of the price.
The structure of the national oil companies within OPEC is also of importance. Even if the price of crude falls to near or below breakeven, they will not stop extracting the oil. One reason is that it would lead to civil unrest in already unstable countries as thousands of jobs are lost.
And secondly, even though viable alternative energy may seem to be decades away, a decision such as OPEC closing down unprofitable wells would be the catalyst to speed this process up. It’s amazing what can be done in the face of real adversity!
Cheers.
Kris.
Comments on this entry are closed.