The Oil Overdose

Oil is done as a "gold" standard. "Black Gold" is now more like "Black Coal". It's everywhere and plentiful. Many countries in the world, and provinces in Canada (like my home province of Newfoundland and Labrador) have bet the farm on unending oil wealth to fuel their growth. Some, like Norway, have banked all those petro dollars into a trillion dollar savings fund that essentially makes every Norwegian a millionaire. Others have used the big bucks to build massive militaries - like Russia; Saudi Arabia; and Iran to name a few. The old black gold has been a God send for those that have it, but those days have come and gone.

Some economists are predicting a relatively short turn around for oil prices - somewhere between a year or two. Very few economists have ventured into the permanently depressed price projection. So, does the evidence support a short term downturn or a fundamental, long-term decline in the price of crude oil? One of the few interesting trends in oil, that has not been discussed much, is the narrowing of the price for oil between the benchmarks of West Texas Crude (WTI) and Brent Crude. Generally, Brent Crude is a world price for oil, while the WTI is the American price. Not too long ago there was a 20% difference in the two benchmarks - WTI being the cheapest. Today that gap has narrowed to the point of near parity. What does that indicate? In two words - European deflation. The European economy is spiraling downward with massive unemployment in places like Spain and Greece, and negative bond issues in places like Germany and Switzerland. In effect, Europe as an economic entity is tapped out.

Then there is the suppression of oil exports into the world oil trade. Most notably Iran. Iran has been severely restrained from exporting oil due to US led sanctions. It has some of the largest oil reserves in the world, and is strategically located to send that oil to market at a low cost. In effect Iran's oil has already been priced out of the market price. Then there is Libya. It has been torn apart by civil war like conditions, inter-tribal warfare, and now Islamic warfare. Its oil exports have been essentially removed from the market. Nigeria is falling into a similar position. Ditto for Iraq, In other words, the glut of oil in the world is really only a small measure of what that glut would look like if and when these countries come back into the market in a significant way.

There is the major factor of new discoveries and technology to consider. A massive oil and gas field has been discovered off the coasts of Israel and Gaza, and is as yet untapped. There are major oil plays in the Kurdistan region of Iraq and to some extent Turkey that remain well underutilized. The dueling technologies of fracking and offshore sub sea "tentical"lines have revolutionized the ability to recover oil from previously trapped locations.

In other words, there is just too much oil in the world, for the foreseeable future, to warrant a scarcity price. The current prices really reflect almost a Debeers - type strategy. Debeers of course controls the world diamond market and ensures that prices remain high by restricting volume in the market. A similar trend is happening with oil. In reality, oil should be at $15-25 per barrel US. Prices above this reflect artificial interventions in the market place, which cushion the fall for many governments that have built societies based on $100 + oil. My province is no different. In fact, even at the current inflated prices, Newfoundland and Labrador looks to be taking a 15-20% hit on its annual budget. Addressing these issues of revenue loss for governments is guaranteed to add further to deflation as consumer confidence crashes and the internal markets realign to economic reality. The same can be said for countries like Russia, Iran, Iraq, Saudi-Arabia, etc.

Predicting the future is a tough task indeed. But, as the CSI saying goes: "people lie, the evidence doesn't." In order to see that future we need to understand demographic trends, political/trade trends, supply and demand trends, etc and synthesize them into one living organism (our world). It's abundantly clear that artificial barriers, primarily caused by speculators in the trading markets, are becoming more and more redundant. As the world economy deflates, which it is, those artificial barriers to the true market value of oil fall away. Expect to see oil decline as the world economy deflates. They go hand in hand, with one racing before the other. Unfortunately, for people like ours that have been subjected to "good times" spending and zero savings, the end of the oil bounty is the end of the party. The government has suffered an oil overdose, and we let them.

Sliding toward Deflation

Think of the world as an engine designed and built to run in a certain way, and at a certain speed. The fuel of the engine is growth.  The chemistry of the fuel is debt. Then imagine one half of the world (the developed countries) running at full speed for 60 years, while the other half of the world (Asia, Africa, and South America) idling. Because our half of the world has been running full speed, we have used the most debt to power our engines, and the world economy has built itself around that fact. Now imagine that so much debt has been used to fuel the engine that it is almost depleted. Meanwhile the other half of the world is just warming up its engine and has plenty of potential debt to consume. What is the logical consequence? One falls while the other soars.

Now superimpose the unfolding China/Russia/BRIC economic order that is forming to reflect that reality. Let's call it the "New Club". Roughly designed to resemble the Soviet days of trading between countries to the exclusion of others, the New Club is rapidly building a new engine. One that attempts to capitalize on each countries strengths and satisfying each countries needs. If that sounds familiar consider Karl Marx's famous borrowed slogan " From each according to his ability, to each according to his need". Essentially, this is the new slogan of the New Club. China has the currency and the manpower. Russia has the natural resources, technology, and the know how. India has the population and science. South America has specific resources. Africa has population and need.

Together, these countries are forming a new world order. They have combined resources to create a new IMF that will compete with the old western IMF to loan money to areas like Africa and South America. They will control the debt that fires those engines. Russia, China and India (almost 50% of the world population) have entered into formal agreements to use their own currencies to pay for resources from each other. They are excluding the US dollar from their market place as an economic foundation. Making it obsolete. They are reaching deeply into Africa in fierce competition with the US to develop that continent as a place to do business. They are quickly becoming the savior for many South American countries who have tapped out their debt in the Old Club and need a rescue line.

Of course, when one grows the other dies, and the other would be the western world, or the "Old Club". Our ability to consume and pay debt has over reached its maximum. That is reflected in the over valued prices we pay for everything compared to what would be paid for the same object in the Club. In some European countries that has led to such things as inter-generational mortgages on homes. In the US it led to the "housing bubble" in 2008. The price we pay for fuel, compared to the actual price per barrel on the international market, is a good indicator of how skewed the economic reality is. While world oil prices plummet, prices at the pump don't. They stay artificially high. The same can be said for the stock markets. They are valued at more than their 2008 pre-crash worth, despite the indebtedness/under-performance of the corporations listed on them. In other words, there is a space between where they should be at in pure economic terms, and where they exist today. An artificial bubble. An artificial economy. Prices inflated to try and maintain our way of life, our government coffers, and our debt.

While there was only one game in town, that game of artificial economy could be maintained to one degree or another. There would be cyclical recessions to try and balance debt vs income vs prices from time to time, but the system could carry on. But, more dollars printed to maintain that growth created inflation in prices.Our system continued to grow fed on inflation rather than real economic wealth. We created a society based on the artificial. Now we are facing a New Club that, for the most part, will not. As the two realities start to compete the Old Club will lose market share for its products, and a glut will create deflation. 

As sales slide, and corporations within the Old Club try to adjust their production downward, each country's GDP begins to shrink - in other words deflate. That leads to serious consequences for an economic order built on growth fueled by debt. A good current example of this is Germany's recent slide. Germany is the economic engine of Europe, and as its GDP continues to fall so do the hopes of the rest of the continent. Another good example is long term bond costs. Muskrat Falls financing was secured for 50 years at less then 3% interest. Indicative that the banks understand what is coming. What else can explain that length of commitment for such a small return on investment. Perhaps one of the most clear examples of things to come is the Brazilian company Rio Tinto. While North American iron ore mines close, scale back or simply don't develop, Rio Tinto is increasing production by 25%. All these corporations compete on the international market, yet they have two starkly different approaches. Perhaps the key to understanding  this is one corporation is in a BRIC country, and a strong m,ember of the new club, while the others are stuck in the old. 

There are signs all around us if we choose to really see them. The world is changing - for the better for some, and the opposite for others. Reality, or deflation as a measure of it, is coming sooner rather than later. There is really no way for governments to prepare for it financially. Instead, and perhaps a very real indication of intent, police forces through out the western world have been armed like military organizations. Like the banks, our governments see the inevitable deflation of our economies, and understand the social chaos that must follow. At that point order will take precedence over rights. It will be a new world for the Old Club.   

 

Masters in Our own House

2012 marks uncharted territory for the province of Newfoundland and Labrador. Unlike years before, the province is facing the crushing realities of the world market place on its best laid plans for economic expansion. It is about to experience the boom/bust cycle that is all too familiar to oil driven economies - like Alberta. The 2007 Energy Plan, the "Masters in our own House" manifesto, was meant to usher in a new era of strategic development. Then Lt Governor Ed Roberts read the Speech from the Throne, as crafted by the Danny Williams government:

"Our people are proud nationalists who believe it is only by affirming our identity as Newfoundlanders and Labradorians that we will realize our goal of economic equality within the federation...Our people are ready to take charge of our future and, under [Premier Danny Williams's] leadership, our province will achieve self-reliance by becoming masters of our own house."
"We as Newfoundlanders and Labradorians aspire, not to perpetual subservience, but to self-sufficiency."
"Our people are not content to tolerate a future of relying on others economically. However, our people have now also learned that we will achieve self-reliance economically only by taking charge of our future as a people."

"Our province will achieve self-reliance". Therein lies the fatal flaw. Just as there is no such thing as a "self-made man" the idea that a people, any people, can be "self-reliant" is a concept hundreds of years outdated. In the age of globalization there are no "islands" protected from the deflationary waves. The western world finds its economies being rationalized to those in Asia, and not the other way around - as was originally envisioned.

Still, the nationalistic governments in Newfoundland and Labrador peddle the idea that somehow the power over the future lies in their hands. That the province is an entity unto itself, and the only thing holding it back is the negative attitudes that disagree. So it boldly, with blinders firmly attached, moves forward. It scored some victories with the oil companies for equity shares in offshore projects when oil was at an all time high. It scored a victory for $2 billion in offset payments from the feds when Martin had a minority government and was facing an election. However, when all things were equal it lost. It lost the Abitibi expropriation battle. It lost the recent NAFTA battle with the oil companies over research and development subsidies. It lost countless battles with Hydro Quebec. On and on it goes.

The problem is that despite all these lessons it does not appear to learn. Fast forward to today. The government is trying to force ExxonMobile to build all three $100 million modules in the province, or pay a large fine for not doing so. Exxon has stated the province can not build the third module on time, due to a lack of resources, and it must therefore build it outside the province or face costly delays in first oil. The Premier has threatened them with fines and "troubled waters" if they proceed. The Mayor of St. John's even boycotted a meeting with a top Exxon official in protest. Its the typical us vs them mentality that takes over when the government of Newfoundland and Labrador doesn't get its way. When it can't "take charge". Because controlling economic forces is not something any country can "take charge" of, let alone a province, in a global economy. It is not an achievable goal.

The province can spend its oil royalties as it sees fit. It can build the Muskrat Falls dam as long as it has enough money saved to leverage the rest in financing. It can do all that. But, it can't make iron ore mines any more attractive on the stock markets in a time of obvious, long term, international declines in consumption. It can't force private investors to invest and buy the mines shares on the stock market. It can not keep its young people from voting with their feet and leaving - a record 4000 or so did in the first quarter of 2012. It can not control the price of oil. It can not even accurately project its income each year from oil revenues. As of today, Brent crude futures are trading at $90 a barrel - 30% below budgeted revenues. The trend is downward as the world market place gets hammered by sovereign debt, consumer debt, and the resulting decline in demand. It will be a long term problem-decades long.

It begs the question: How is the provincial government reacting to the change? The answer is the same as usual. Fighting others to perpetuate the myth that we are "masters in our own house". No updated financial document to amend the budget to reflect the obvious massive deficit coming for this year. No plans to halt the Muskrat Falls development despite the mining companies in Labrador being frozen by the chill of world wide deflation. No plans other than the original - hell or high water - blinders firmly on. As we used to say in the army: No plan survives first contact with the enemy. To put the icing on the cake, the PC government passed Bill 29, which essentially guts access to information in the province, so that it can hide all those pesky little bits of reality that might make it known its not masters of its own House.