COLUMN - Do we need a recession to balance the oil market?
(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, July 26 (Reuters) - Led by University of California Professor James Hamilton and Fed Chairman Ben Bernanke, economists have sought to quantify the impact of oil shocks on economic performance.
The conventional approach treats oil prices as a (partly exogenous) input into forecasts of growth. The causality runs essentially in one direction from oil prices to economic growth.
But it is worth reversing the analysis and examining growth as an input into the formation of oil prices -- in particular the role of periodic recessions ensuring there is a sufficient buffer of spare capacity in the oil market to absorb supply and demand shocks and stabilise prices.
Recessions leave a legacy of spare capacity that mutes upward pressure on prices, at least until the next expansion has matured and resource tensions re-emerge. They play a crucial role in helping balance the market.
THE CAPACITY MYTH
Lack of spare capacity is usually identified as a risk factor in oil forecasts. But few analysts and forecasters have asked where spare capacity comes from and what governs its availability.
Since the 1970s, most spare capacity has been concentrated in OPEC, especially swing-producer Saudi Arabia. That has given rise to the myth, fostered by Saudi officials, that the kingdom deliberately invests in spare capacity to calm price swings as part of a grand bargain with the United States (swapping spare capacity and price stabilisation for military and diplomatic protection).
But there is scant evidence for this. This historical record shows that spare capacity has been far more variable than either supply or consumption. It looks more like a residual from noisiness and forecasting errors in oil demand than something which has been consciously developed.
Since 1994, the volume of spare capacity held by OPEC has ranged from as little as 710,000 barrels per day (Aug 2004) to as much as 6.94 million bpd (April 2002), according to estimates by the U.S. Energy Information Administration (EIA).
Most spare capacity has emerged following slowdowns in global growth (the Asian crisis in 1997-98, the recession in 2000-2001 and the recession in 2008-2009). By their nature slowdowns tend to be unexpected. The pattern of spare capacity suggests it emerges as a result of miscalculations about demand based on extrapolating previous trends.
In a more realistic model, Saudi Arabia and other states invest in capacity expansions on the basis of projections of strong demand growth and are then surprised when the economy falters and demand falls.
The same pattern of recessions followed by the emergence of (unexpected) spare capacity is evident in the 1970s and 1980s (Charts 2 and 3). Deep recessions in 1974-75 and 1980-82 left oil demand far below previously forecast levels. Combined with the development of new resources in the North Sea, poor economic performance was responsible for the massive overhang of spare capacity that emerged in the mid-1980s and a decade of largely muted prices.
The capacity myth suggests Saudi Arabia and its allies invest considerable sums developing new fields in the desert simply to leave them unused to reassure nervous investors and oil consumers.
The reality is Riyadh develops new fields when it thinks there will be demand. However given long lead times between commissioning and delivery and the uncertain nature of demand-forecasting the kingdom sometimes finds itself (temporarily) with too much production capacity and some is shut in to forestall a collapse in prices.
Saudi officials currently claim the kingdom has capacity to produce around 12.5 million barrels per day, compared with current output of 10 million, leaving a cushion of 2.5 million barrels per day. But many oil analysts are privately sceptical.
The kingdom has not released field by field data on either production or capacity. Much of the unused capacity appears to be older fields and wells that are more difficult to produce or yield poor quality crude, and there are likely infrastructure constraints.
In any event, much of Saudi Arabia's spare capacity, like that in Kuwait and the UAE, appears to be the residual from previous demand and supply forecasting errors, notably the failure to foresee the worst recession since World War Two in 2008-2009, rather than shiny new facilities expensively developed for market balancing.
Most analysts continue to forecast strong consumption growth in the remainder of 2011 and throughout 2012. With the prospects for supply growth restricted, one prominent forecaster has warned the supply-demand-inventory-capacity balance could tighten again next year to replicate conditions seen in 2008.
But the exceptional supply tightness and price spike in 2008 were eventually ended by recession. Observers are still divided about the role oil prices played in hastening the downturn compared with other factors. But there is no doubt the recession relieved pressure on supply and capacity, and that without it oil prices would have been far higher over the last three years.
The question is whether another recession will be needed in 2012 if spare capacity again dwindles to very low levels?
Forecasters have warned prices are rising in part because of fears about falling spare capacity levels. The implication is prices will continue rising until a more comfortable level of spare capacity has been restored.
Since supply is not responsive to prices in the short to medium term, the only way to raise spare capacity is to curb demand. While some demand destruction can be achieved through higher prices and efficiency gains, particularly in the advanced economies, the only certain way to cut consumption and boost spare capacity is via a slowdown in the advanced economies and/or emerging markets.
If the market is worried about lack of spare capacity, the only solution in 2011 and 2012 may be a slowdown in global growth. Since oil demand is relatively insensitive to price but more sensitive to income, rationing may have to come through recession rather than efficiency improvements.
OIL AS SPEED LIMIT
The high levels of OPEC spare capacity recorded in the 1980s and 1990s were the legacy of demand forecasting mistakes in the 1970s and early 1980s. Now the spare capacity has been (largely) re-absorbed, spare capacity in the oil market has re-emerged as the key "speed limit" on global growth and inflation.
St Louis Fed President James Bullard and analysts at Goldman Sachs have both made the point that availability of oil, not workers, has become the key constraint on global growth. The best measure of the output gap may be spare capacity in the oil market, rather than the unemployment rate or estimates of unused manufacturing capacity in the United States.
If oil supply has indeed become the constraint on non-inflationary growth, there may not be much of an output gap left. Rather than being at an early stage, the upswing may already be starting to push up against capacity constraints and be surprisingly mature.
In recent decades, forecasters have become used to business cycles averaging five years and in some cases longer, but prior to World War Two cycles were shorter and sharper, often half as long. Most forecasters have assumed the current expansion would not peak until 2015-16 or later.
But that might be far too optimistic. Based on the pressures already evident in the oil market, the global growth might be forced to slow much earlier.
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