Inside investment: Pouring oil on troubled waters


Andrew Capon
Published on:

A US recession could be short, shallow and relatively benign for the rest of the world if oil price falls in 2008.

In the immortal words of the narrator in the British comedy classic Withnail and I: “Even a stopped clock tells the right time twice a day.” Market commentators should have that maxim tattooed on to their foreheads, lest they get carried away by their successful crystal-ball-gazing. With that caveat duly out of the way, prepare for a boast or two.

This time last year this column predicted that during 2007 the debt binge and the boom in ever more complex structured credit would both come to a sticky end. In June it said that the credit cycle was turning almost imperceptibly. Two months later we had scored a notable hat trick.

However, it is now time to give up on the doom and gloom. Quite frankly, there is far too much of it around. Suddenly, those who were wearing rose-tinted spectacles and writing about a new economic order in which the business cycle had been abolished have turned into bears. Those who were in the bearish camp are now gleefully predicting a financial apocalypse on a scale not seen since the Great Depression. To borrow a phrase from Michael Winner: “Calm down, dear.”

One thing most economists now agree on is that the US will have a recession. For once, conventional wisdom is correct. A report last November from the Conference of Mayors predicts that the value of residential housing in the US will fall by $1.2 trillion this year. That is close to 10% of US GDP and this negative wealth effect will test the resilience of the US consumer.

Further, outstanding commercial and industrial loans and the commercial paper market fell by 9% from their peak in August through to November. In short, both consumers and businesses will have little choice but to tighten their belts. The credit crunch will continue. Even if banks trust each other again, their first concern will be to rebuild balance sheets and shore up capital ratios.

So far, the assets that have been written down have been mostly related to residential mortgage backed securities. The economic slowdown will put credit card receivables, other parts of the ABS markets and mainstream loan books in the spotlight. Defaults will rise and so will bad-loan provisions. This backdrop makes it hard to be bullish about US asset markets.

However, there are reasons to be cheerful. The weak dollar has given the US export sector a shot in the arm. Exports hit a record $140 billion in September. At the same time, the US trade deficit has fallen to its lowest level since May 2005. US imbalances are being addressed and the dollar does not need to fall further to support this trend.

However, the biggest fillip of all for the world economy in 2008 could be a falling oil price. The oil price is one of those perennial mysteries – probably even to commodity specialists (though they wouldn’t admit it). In the spring of 1999, the Economist ran a cover story that declared that the world was drowning in oil. It concluded that $10 a barrel was probably optimistic and oil could be headed for $5.

Now, we are told with equal conviction that oil is going north of $100. Which is right? As with most things, the truth probably lies somewhere in between. Saudi Aramco pumps oil out of the ground at a cost of less than $2 a barrel. New refining technology makes Saudi sour crude viable at $4 a barrel and Canadian tar sands at $40. Nor is supply as threatened as the “peak oil” theorists would have you believe. For example, the vast Empty Quarter of Saudi Arabia has barely been explored.

For the global economy, the high oil price is an additional and unwanted stress. It is inflationary for oil importers. Chinese consumer price inflation has just hit an 11-year high. Inflationary pressures in the US might constrain the ability of Federal Reserve chairman Ben Bernanke to aggressively cut interest rates as the economy slows. The weak dollar and soaring oil price also transmits inflation back to oil producers via booming monetary aggregates.

Opec can choose to pump more oil and force the price down. If it does not, a deeper US recession than is necessary threatens soaring inflation in the Gulf Cooperation Council states and a messy collapse of the grouping’s dollar peg. In the longer term, Opec and the other oil exporters face a strategic choice. If the oil price remains this high they risk turning the US, the most technologically advanced and entrepreneurially minded nation on earth, into an exporter of alternative energy within a generation.

If a fall in the price of oil also precipitated the economic collapse of Iran and regime change, few would weep. It would help the US and the UK extricate their troops from the proxy war they are fighting in southern Iraq. Cheaper oil is a potential win-win, for the world economy, oil exporters and global stability. Let it flow.