Sunday, February 05, 2006

Oil and the dollar

The Washington Times
February 5, 2006

The World Economic Forum, which convened recently in Davos, Switzerland, looked at risks facing the global economy. The WEF offered a laundry list of potential turbulence-causing events and assessed the probability of each occurring. Among the biggest risks confronting the world included oil-price spikes of different magnitudes, terrorist attacks of variable intensities and sizable declines in the value of the dollar.
The WEF's Global Risk Program, according to a report in the Wall Street Journal, assigned a probability of less than 1 percent that the price of oil would spike to $100 a barrel in 2006. Chances are better than one in five, however, that the price of oil, which has been flirting with $70 in recent days, would reach $80 a barrel this year. There was less than a 1 percent chance that the dollar, which appreciated between 10 percent and 15 percent against the pound, euro and yen last year, would decline by 40 percent; the likelihood that the dollar would fall by 20 percent, however, was as high as 10 percent.
An energy-crisis simulation conducted at the WEF examined the likely effects of a terrorist attack that removed from the market 5 percent of the world's daily oil demand, which totals about 85 million barrels. Coincidentally or otherwise, that amount of withdrawn oil (4.2 million barrels) precisely equals the daily output of Iran, the world's fourth-largest oil producer. Based on October production levels, the U.S. Energy Information Administration reported last week that Iranian oil output trails only Saudi Arabia (9.5 million barrels per day), Russia (9.2 million) and the United States (4.25 million).
How might the world react if oil output falls by 5 percent? The Wall Street Journal reported that the chief executive of Saudi Aramco assured the WEF that Saudi Arabia could produce an extra 1.5 million barrels per day. The crisis simulation concluded that increased output by other producers and strategic petroleum reserves stockpiled by developed countries could handle the balance (between 2.5 and 3 million barrels) of the shortage.
Assuming that the lost output could be replaced for at least a year, the crisis simulation nonetheless concluded that the price of oil would still surge as high as $120 per barrel amid geopolitical concerns over the lack of capacity to meet further output disruptions. Beyond any additional disruptions, however, it must be noted that there are serious concerns within the oil industry questioning Saudi Arabia's ability to ramp up output from 9.5 million barrels to 11 million barrels and sustain production at that level for a year or longer. Thus, relying on Saudi Aramco for an extra 1.5 million barrels may prove to be extremely foolish.
What might be the economic impact of $120 oil? When Mideast oil prices soared from $3 a barrel in October 1973 to nearly $12 a barrel four months later and when much of the same oil soared from less than $13 a barrel in 1978 to more than $40 in 1981, the world's total oil expenditures approximated 7 percent of world gross domestic product (GDP). Last year, when oil reached $70, oil expenditures approximated 4 percent of global GDP. At $120 per barrel, however, oil expenditures would approach 8 percent of global GDP, a level higher than that produced by the price spikes of 1973-74 and 1979-81, which generated the two deepest recessions in America since the Great Depression. Moreover, because the United States imports nearly 14 million barrels of petroleum per day (more than twice the import levels in 1973 and 1980), a price of $120 per barrel would increase the nation's petroleum-import bill by $25 billion per month (and $300 billion per year).
Recall that last year's trade deficit totaled about $725 billion, which reflected an annual increase of more than $300 billion since 2002. Now, consider the trade deficit's underlying growth trend independent of any oil-price spikes; then assume that U.S. consumers reduce their demand for non-oil imports by $150 billion per year in order to pay for half of the $300 billion annualized increase in the nation's oil-import bill induced by $120 oil. The result is still an annualized trade deficit above $1 trillion. All of a sudden, the prospect for a huge fall in the dollar becomes much more likely. With foreign investors effectively financing 100 percent of the U.S. budget deficit, which will approach $400 billion this year, all bets would be off.
In an environment of a plunging dollar, the question becomes: How high would U.S. interest rates have to go in order to induce foreigners to continue lending money to America's overstretched consumer and fiscally irresponsible federal government?

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