CIBC World Markets analysts recently predicted that oil would sell for US$200 a barrel in 2012, as oil supplies grow ever tighter relative to demand. That would imply a continued global boom for the next four years, which would bring inflation, perhaps validating CIBC's prophesy as the dollar went the way of the 1923 Reichsmark.
All the same, that's not the way I'd bet; I think $50 is more likely. We are probably not quite at the end of this unprecedented oil and commodities bubble, but we are surely getting close.
To take the hyperinflationary possibility first. The St Louis Federal Reserve has since 1991 calculated a monetary statistic "money of zero maturity", which is M2 minus small time deposits plus institutional money market funds. In the absence of M3 statistics, discontinued by the Federal Reserve in March 2006, St Louis' MZM is a decent measure of broad money supply. MZM increased by a moderate 9.18% in 2007. However in the three months to April 14 2008, it has increased at an astounding annual rate of 30.3%, reflecting the massively expansionary monetary policy the Fed has followed since January.
If the Fed keeps up that rate of growth for the next four or so years, then, since prices follow monetary growth, by the end of 2012 prices would have risen by about 236%. In other words, to have the same real price as today's $115, oil would sell for $386 per barrel. A price of $200 per barrel would then represent a moderate oil price, reflecting a decline in real oil prices to little more than half today's level in real terms. Needless to say, if the US dollar had been alone in suffering this level of inflation, the euro would in 2012 be selling at over $5 and the yen would be running at $1 = 28 yen.
So how likely is this hyperinflationary scenario, and how likely is $200 oil without it?
The hyperinflationary scenario depends on the Fed continuing to increase money supply by around 31% per annum for the next four years. That's not quite impossible. Consider a world in which Federal Reserve Board chairman Ben Bernanke has little or no fear of inflation, but where house prices are an essential political measure of the Fed's success. In that case, to prevent house prices from catastrophic decline, Bernanke might continue to indulge in stimulatory policies, lowering interest rates as far as practicable towards zero, buying essentially unlimited quantities of dodgy housing debt from the banking system and assisting in bailouts of any banks that got into trouble.
A sloppy populist administration, were such to be elected in November, might ally with the Fed in devising a series of ever-more expansionary "stimulus packages" while prevailing on the Fed to support the Treasury bond market to help it fund its trillion dollar deficits. It might assist the process by erecting trade barriers against Third World imports, which would be seen as taking away jobs; such barriers would restore few jobs but might well produce huge increases in import prices. The rest of the world would doubtless go into recession as the US withdrew partially from the world market, so oil and other commodity prices would decline in real terms, but the dollar prices of non-oil imports could be rising so rapidly that the overall price level continued to inflate.
Sound horribly plausible? I'm rather afraid it is. The 2008 campaign has shown that the quality of economic thought among both the US primary electorate and the political class has deteriorated markedly in the past decade, so that there are few barriers today to rampant protectionism, rising inflation and ever-increasing government spending. There are counterproductive policies of the 1930s through the 1970s that would probably be avoided today, but not many of them.
There are thus only two factors that may save us from 30% inflation and $200 oil by 2012: a revival of good sense by the Fed and the politicians (very unlikely) or a full-scale revolt by dealers in the US Treasury bond market. The latter is not at all improbable; the government's borrowing is increasing substantially, with the current year's deficit heading towards $500 billion even before recession has properly taken hold, so bond markets are going to be asked to absorb a LOT of debt. At some point, even with the Bureau of Labor Statistics doing everything it can to massage inflation figures, bondholders and dealers will come to realize that they are being asked to buy Treasury bonds that yield less than zero in real terms.
A good healthy "buyers' strike" would then push up Treasury bond yields, probably forcing Bernanke's resignation (as it did the resignation of his predecessor G William Miller in 1979) and force a tighter monetary and fiscal policy on the US powers that be. It is a consummation devoutly to be wished; one's only doubt is that inflation has been rising steadily now for several years and yet Treasury bond yields remain stubbornly around their levels of 2004. Continued heavy buying by the less than stellar intellects of Middle Eastern and Asian cash-rich central banks could prevent a catharsis that all should desire.
Assuming that we get a buyers' strike in the Treasury bond market or (less likely) a revival of good sense in the Fed and Treasury, inflation is unlikely to soar to over 30% and thus oil is unlikely to trade around $200. In such an event, interest rates would be increased to begin the lengthy task of wringing inflationary forces out of the system. That would reduce the flood of liquidity in international markets, which would have two effects. First, it would reduce the rate of world growth, affecting particularly those countries such as India and Latin America whose fiscal (India) or balance of payments (most of Latin America) position was already somewhat weak.
Second, it would greatly reduce the loan capital available to international speculators, which have been an increasingly important factor in rising oil, gold and commodity prices in the last year. There are reports that hedge funds have already been compelled to reduce their leverage to a maximum of five times capital. I would tend to be skeptical of such reports, but clearly if interest rates were forced upwards the arithmetic both for hedge funds and for those who lend to them would change radically.
That scenario, of slowing world growth, particularly in markets with heavy real estate exposure (such as the US, Britain, Spain and Ireland) or in over-leveraged emerging markets, would be devastating for commodities markets. Speculative demand would quickly be removed from them, partly because of the bankruptcy of the speculators, and real demand would also be somewhat reduced. Commodity prices would fall towards equilibrium levels.
In the case of soft commodities, the fall towards historic levels would be rapid. Production is already being ramped up because of current high prices, so it is likely that in 12 months time there will be a glut of most crops. The ethanol from corn politically inspired disaster is registering even in the minds of US politicians, so even if the bizarre and counterproductive US subsidies for that process are not repealed, they will not be extended. World food consumption is increasing only relatively slowly, with some change in mix as wealthier Indians and Chinese eat more meat, so with a further slowing in consumption growth it will take very little time for production to catch up.
For gold and silver, the trend depends on the outlook for global inflation. If low interest rates are allowed to persist until inflation has got a real grip, it is likely that inflationary expectations will worsen, driving up gold and silver prices further.
Even when interest rates are raised, confidence in government firmness against inflation will probably be slow to revive, so speculators and investors may continue to hold gold and silver as a hedge - after all, with rising interest rates stock and bond prices will be declining, so there won't be an obvious alternative home for their money.
Thus the equivalent 2012 prediction to $200 oil, $2,000 gold, may very well be possible, although it is likely that such a price will be seen only early in the year, with the overall trend by then, perhaps two years into the fight against inflation, being firmly downwards.
Finally, the oil price itself. Two factors have been driving the rise in oil prices. One, rising demand, has been discussed in relation to food and can be expected to follow the same pattern. As the world economy slows, demand will increase more slowly, while the speculators will be squeezed out of the market by higher interest rates. Nevertheless, absent changes on the supply side, one might still postulate 2012's oil prices to be close to current levels.
It is on the supply side that a global recession makes the most difference. Here the continually rising price of oil over the past five years has awakened primitive nationalism in oil-producing countries, causing them to maltreat foreign oil companies and attempt to squeeze as much government revenue as possible out of the oil goose that is laying so many golden eggs.
New oil discoveries are becoming more and more difficult because in only a few countries are oil companies with modern exploration techniques given the right incentives to search aggressively for oil. Even Russia, the white hope for greater oil production five years ago, has seen its production begin to decline in 2008, while Mexico (closed oil sector), Venezuela (socialist fruitcake) and Nigeria (kleptomaniac government that taxes oil revenues at 98%) have all seen oil production decline by more than 10% since 2006.
There are a few counterexamples: Iraq’s oil reserves have doubled since that country was reopened to international exploration in 2003, while Brazil, whose Petrobras enters freely into joint venture agreements with Big Oil, has made major new oil discoveries recently. However, while oil prices continue to rise the search for new oil sources is likely to be restricted to only a limited number of geologically promising areas.
Once oil demand starts to tail off and interest rates rise, the current situation will reverse. Badly run countries such as Venezuela and Nigeria will quickly run out of money. Current policy will then be reversed, and the major oil companies will once again be allowed to explore and produce on an efficient and profitable basis.
Oil prices will then decline more rapidly, and wealthier and better-run oil producers such as Russia and Saudi Arabia will also find themselves in difficulty and become less recalcitrant in international politics and less resistant to help from the multinational oil companies.
Slackening oil demand will also give time for new supply to come on stream and for environmental objections to massive supply from tar sands and oil shale to be overcome. The result, as in 1981-86 will be a decline in oil prices, gradual at first but probably accelerating until a floor is reached at which new exploration becomes pointless and the oil price is once again as far below its long term marginal cost as it is today above it.
By 2012, that process will only have gone part way; nevertheless an oil price of $50 before the end of that year seems probable. Oil prices may well be on a long-term upward trend, as supplies become restricted to geologically and politically more difficult areas, but $50 per barrel is already (absent hyperinflation) well above the real oil price in 1986-2002 and should easily prove sufficient to reward both efficient exploration and more intensive production from the tar sands of Orinoco and Athabasca.
