The New Millennium Oil Crisis: Why the oil crisis could result in a global recession The New Millennium Oil Crisis

- Notes from a presentation given by Jeffrey G. Rubin, chief economist and managing director, CIBC World Markets, at the Chateau Montebello, Montreal Exchange Canadian Annual Derivatives Conference -

One of the most intriguing presentations at the recent Canadian Derivatives conference was given by CIBC chief economist Jeffrey Rubin who began by noting that the current oil shock should have as great if not a greater, effect than the shocks of 1973-74 and 1979. It should certainly impact pump prices more, if nothing else. Moreover, the current problem is genuinely an energy crisis (as opposed to merely an oil crisis) thanks to the explosive rise in the price of natural gas accompanying the dizzying spiral in crude prices.

Essentially, Rubin's concern for the future of the world economy and more specifically the oil price is that in the two previous major shocks, OPEC has closed their production right down, yet now they have the taps wide open and yet we are still subject to staggering prices. After all, there has already been a 3.2 million barrel per day increase since the start of the year by OPEC members yet the price keeps rising. More significantly, Rubin noted that there is really only two million barrels per day of capacity currently available to the OPEC members.

Meanwhile, outside the confines of the OPEC cartel, virtually nothing is happening. After all, in previous crises, there was a rush to find new supplies by increasing exploration in the North Sea off the British coast, and in Alaska. It is interesting to examine why the non-OPEC oil nations aren't simply ramping up production to meet demand. And the answer is that there aren't any massive oil resources to exploit outside OPEC any more, according to Rubin. The advent of the North Sea supplies has helped cut Middle Eastern supplies on the world market to 18 percent from 30 percent, but there simply aren't as many oil resources around any more in the US or anywhere else.

Rubin discussed the rather interesting Hubbert curve, created by an American oilman, King Hubert who used his technique to predict the level of reserves in oil wells. In 1956 the Hubbert curve reckoned that US oil reserves would reach their mid-point in 1972. In fact it was 1971. Rubin noted that the US now has 25 per cent less oil than the 1970's.

Rubin also noted that there are diminishing returns to drilling in essentially all regions - most oil was discovered by 1970. In the 1979/80 oil crisis a huge drilling increase did not lead to a significant quantity of oil discoveries. The Middle East still has the world's biggest oil reserves. Roughly, some three to eight years of global consumption equals about 1/8th of the Middle East's existing oil reserves. However, world energy demand is currently growing at 1.5 percent per annum. "Soon we will hit a supply wall," Rubin noted, not altogether cheerfully. If this wall is hit head on, energy prices will simply explode. However, the market already appears to have sensed this growing scarcity, so such a full-on impact appears relatively unlikely. Nevertheless, if the world economy doesn't manage to respond through energy cuts then the upside for oil and energy prices could be colossal.

Naturally, hitting the supply wall either softly or in a full frontal fashion is likely to have a significantly calamitous effect on the world's GDP. Moreover, it would mean a very acute need to reduce energy intensity per unit of GDP for the economies which want to be ravaged least. Rubin reckons trying to deal with this problem could halve global growth within the next three to four years. He believes that West Texas Intermediate is going to average 40 US dollars throughout next year and will plateau soon after at around 50 dollars without much hope for a retreat of any significance. Equally, if the oil demand curve collides head on with the supply wall, then prices could reach 80 US per barrel! Global recession on a grand scale would then eventuate... True, the US economy is less dependent on oil supplies than it previously was. However, large swathes of South-East Asia such as Malaysia and Thailand would be much more heavily affected thanks to their greater reliance on manufacturing industry.

In the long run, the world economy has enjoyed a 30 per cent decline in energy intensity, but now it must manage at least another 20 to 25 per cent. Meanwhile, inflation in the US will be pushed to 4.3 to 4.5 percent regardless of any behavioural assumptions. Yet in 1973 and 1980, wages undoubtedly chased oil prices, which if repeated would set off a greater inflationary spiral.

Indeed, the greatest danger is economic. Despite the bond market dismissing headline inflation and opting for core measures, the fact is that with householders seeing some 20 per cent of their budgets affected by fuel price rises, their propensity to push inflation through higher wage demands is considerable.

The best-case interest rate-wise in the US is for at least two rate hikes, but the Fed is simply not going to stand idly by with unemployment below or equal to four percent and inflation above the four percent level.

Against this oil price background, Rubin is highly bullish for oil stocks. As they trade on a multiple of cash flow, they currently really only price in 30 USD when Rubin sees prices averaging 40 USD in 2001.

Additional reporting by Patrick Young.

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-- Martin Thompson (mthom1927@aol.com), November 02, 2000