There was a time when central bankers used to fight high oil prices with interest-rate hikes. But we are now in a different era with that equation, and central bankers are more likely to lament, as Ben Bernanke quipped in his spring 2011 press conference, that “the FED can’t print oil.” Yes, precisely. At the zero bound of interest rates and with debt saturation coursing through the private and public sector, the developed world faces not an inflationary restraint from oil prices, but rather an additional deflationary barrier. Welcome to the new oil cycle.
In the old oil cycle, new supply of petroleum was brought online to capture rising prices. In the new oil cycle, declines from existing fields neutralize this new supply, for a net global supply gain of zero. In the old oil cycle, recessions benefited large consumer countries like the United States as oil prices fell, giving a boost to the economy. In the new oil cycle, the price of oil falls only for a short time before resuming a higher swing. In the old oil cycle, the developed world set the oil price through swings in its demand. In the new oil cycle, the developing world, with its much lower sensitivity to high prices now sets the floor on oil. Most of all, the new oil cycle caps growth in the developed world. The new oil cycle kills the economies of the OECD nations.
This week, JD Power and Associates released its 2012 sales outlook for the US light vehicle market. I’m quite thankful that Calculated Risk, the long-time blog on the US economy, keeps an updated chart series of this data, because it will help set the context for JD Power’s outlook and where we are in the current oil cycle. The forecast? For the annual rate of US automobile sales to reach 14 million by the second half of 2012. That would make for a healthy advance in auto sales from the current rate, around 13.25 million. Let’s take a look then at the multi-decade chart for light vehicle sales from 1967-2011.
Anyone familiar with a chart of the US stock market or US employment will immediately spot the long-arc trajectory here that begins in a very familiar place: 1982. That was the dark place, after twin recessions and a rude (but healthy) Volkering of inflation, from which the great bull market in stocks was born. This reflects current discussions of 1) how much the stock market could recover, 2) how much the employment market could recover, and 3) how much wages or real GDP could recover. The JD Power forecast for next year, if it comes to pass, would only restore vehicle sales to levels last seen in the 1990s.
I won’t digress (much) toward the enormous mistake the US has made in continuing to invest billions of dollars in public capital into the Auto-Highway Complex. But let’s at least disabuse ourselves of the notion that automobile transport has been a free-market phenomenon for nearly all developed nations. Both in Europe and in the US, automobile manufacturing has been a key part of the industrial (and political) structure for decades. And I am merely using this sector as a current example of a beloved and favored means to economic growth that no longer works for economies now that we’ve entered the new oil cycle.
In the old oil cycle, higher prices would have triggered new gains in MPG standards from the automobile industry, no doubt unleashing a new round of higher automobile sales. In the new oil cycle, sales of new autos are hampered as car owners hold on tight to existing vehicles. There isn’t enough growth in the wider economy to turn the fleet over. This is precisely the analytical mistake forecasters of future EV sales (electrical vehicles) continue to make when happily predicting broad adoption of electric power. Adoption is glacially slow because fleet turnover is slow. And fleet turnover is slow because the economy has been reduced to a much lower level of operation.
I recently showed data which quantifies the dramatic drop in oil consumption since the 2007 highs in the US economy. As usual, the correlation between economic growth and energy consumption is nearly perfect. The drop in European oil consumption has also been quite pronounced. I might add that in the case of Europe — which enjoys broad coverage in electrified rail transport — the reduced oil consumption is more notable. The United States entered the current decade with a lot of discretionary oil demand that was fated to come offline, but that was not the case in Europe. The continent has been weaned from casual oil use for decades, mostly through high taxes. But that did not prevent a new low in consumption post-2006, when prices began to soar — with predictable effects. Stuart Staniford of the Early Warning blog presents the chart below with the latest data. It’s notable that Europe’s economy, the largest in the world, has shed a million barrels per day (mbpd), from 15.5 to 14.5 mbpd.
The Rescue Myth
Let’s pause here and be as frank as we can be about a rather widespread belief in the Western world shared among economists, policymakers, technologists, and corporations: The price of oil will eventually drop, and the global economy will also grow. Is that right? Well, unless you’ve been living in a cave, OECD countries are currently in the throes of a debt crisis, with at least 15% of the population unemployed or underemployed. Meanwhile, North American oil prices, as measured by the WTI benchmark, have just rejoined Brent at levels at/above $100 a barrel. And Western economies are now supposed to recover from this position? What price of oil are we to forecast, should the vast spare capacity and idle labor of the OECD come back online? I spoke to this issue back in 2009 in a post called Overhead Crush:
A concept that’s key to resource depletion is the higher volatility phase, in which both price and supply start to hit ceilings and floors in accelerated fashion. This tends to appear first during the actual peak supply period, or peak plateau period. The pattern has been seen in previous eras in such things as wood, fish, and whale oil. When the post-peak phase gets underway the price amplitude increases even further, playing havoc with supply and demand. As demand gets killed, and then finally collapses, it causes confusion about supply. But then, as demand returns, any questions about supply are soon answered as demand once again bumps up against the supply ceiling.
Visually, we can think of demand in this phenomenon as being in a kind of contracting triangle. Every time consumption resumes after a previous demand crash, it hits the ceiling at a lower level. This is the point where, if you find yourself living in the age of biomass and wood, you get rescued by coal. For example. This is also the point where, if you are living in the age of oil, it’s less likely you get rescued.
Normalcy Bias and the Problem of Growth
Normalcy bias, rampant in the West, leads most to conclude we’ll be rescued. Some magical combination of new technology, new policies, or miracle energy resources will soon arrive. Even on the conventional end of this spectrum, there is still a generalized belief in the inherent ability of the system to resume growth. In a recent paper from the New America Foundation, The Way Forward (Alpert, Hockett, Roubini), we find eminently reasonable solutions that target the system as it once was, but not the way it’s operating now. While the authors move beyond either purely Monetarist or Keynesian approaches in their solution set, their attention to energy inputs is far too moderate. Only a policy recommendation that foregrounded energy as the primary lever to apply to Western economies, rather than merely including it, would now have resonance. It is the energy-intensity of America in particular that must be confronted, not only in its domestic consumption but in the global energy inputs it commands through its outsourced production. Let’s remember that oil, until it is eclipsed by coal, remains the primary energy source of the world, with a 33.56% share (2010, BP Statistical Review).
And now the question: If growth faces nearly insurmountable barriers, absent widespread debt writedowns or even a debt jubilee, then why are German Bunds or US Treasuries currently operating as safe havens? Do Germany and the US not occupy the same economic territory as broader Europe? A demand shock for Asian consumer goods, emanating from a collapsed Europe, would crush Asian demand for the infrastructure goods that Germany produces with such expertise. Global markets are therefore making an enormous mistake. In the midst of a sovereign debt crisis now hitting the developed world, they are pricing the risk as though this were like the 1980s crisis that hit countries in Latin America. But this is not a crisis in which banks in Boston, having lent billions to Brazil or Argentina, write down debt while engines of growth in Japan, Europe, and the US move forward. Rather, this is the endgame of post-war growth in the West.
And it would seem that even ‘safe haven’ bond markets have started to price in this reality. As Morgan Stanley shows in this chart of recent action in German Bunds, the price advance (and thus the yield decline) in bunds has started to slow as the recognition phase gets underway on system-wide EU debt.
(chart courtesy of Joe Wiesenthal at the Business Insider)
The developments in Germany’s “safe-haven” status were addressed by Ambrose Evans-Pritchard on November 17:
Andrew Roberts, rates chief at Royal Bank of Scotland, said Asia’s exodus marks a dangerous inflexion point in the unfolding drama. “Japanese and Asian investors are for the first time looking at the euro project and saying `I don’t like what I see at all’ and fleeing the whole region.” The question on everybody’s mind in the debt markets is whether it is time to get out Germany. The European Central Bank has a €2 trillion balance sheet and if the eurozone slides into the abyss, Germany is going to be left holding the baby.”
The Vulnerability of Having Sovereign Debt As Your Core Asset
All across Europe, the sovereign debt of EU nations forms the core asset base of key institutions critical to systemic cohesion. This debt is a call option on future growth — a call option that most assumed would never decline so catastrophically in value and that could presumably always be rolled over. In the old oil cycle, such sovereign debt problems were merely a function of profligacy. In the new oil cycle, a debt crisis is no longer solvable with growth. Devaluation or jubilee are the only options. The loss to society will be borne most directly by those who hold sovereign debt as their savings. But in our present situation, it will not be a sub-set of the West that bears the loss, but the entirety of the West. The time of Containment is over.
Gold’s Critical Role at This Time
The recognition of dim, future growth has only now begun to unfold. In an earlier report, I explained that the framing of gold prices as insurance against future inflation was, at least for now, wrong. Instead, gold continues to trade along the contours of growth’s terminal phase and the unpayable debt now left in its wake. This impending instability, or discontinuity if you like, is what will drive the gold price over the next few years, along with policy maker’s response(s) to our decline.
In Part II: Understanding Where Gold & Silver Go From Here, I offer two distinct price pathways for gold, specifically in light of the great threshold that we’re now crossing in developed-world debt saturation and the end of growth. These two price pathways will be greatly influenced by how policy makers and central banks respond to this final phase of the crisis. In addition, I also offer a view as to silver’s relationship to gold along the two pathways I define. Timing is of the essence, because oil prices have just punctured the great reflationary recovery of 2009-2011.
Click here to access Part II of this report (free executive summary, enrollment required for full access).