June crude oil futures traded above $70 a barrel last Friday before retreating to close at $68.44. Part of the driving force behind the rise to $70 was a report issued by Goldman Sachs (GS-NYSE) that it was revising its oil price forecast for the end of 2009 to $85 a barrel from its prior $65 forecast. Briefly, the Goldman Sachs' higher price predictions are based on its belief that the world has entered into a four-part bull market for crude oil. They view the current rise to $65 as reflecting the normalization of "pricing dislocations caused by the credit crisis" and its impact on oil demand. They believe that most of the yearly oil demand decline anticipated has already occurred and that demand is stabilizing and should head higher in the future as the recession ends and economic growth resumes. Their second phase is that OPEC's production cuts coupled with stable and slowly rising oil demand will support higher prices as inventories contract and is the principle reason for their 2009 year-end price forecast hike.
The third bull phase will see oil prices rising to $90 from the prior estimate of $70 a barrel in order to drive the resumption of investment in developing new oil resources. Their final phase will take oil prices to $95 a barrel by the end of 2010 as energy scarcity becomes a greater consideration. Longer term, Goldman Sachs suggests that oil demand in developed economies will need to shrink in order to support increasing consumption in the BRIC (Brazil, Russia, India and China) nations. This is an interesting point because it suggests that oil demand in America, Europe and Japan will be less important for the globe's petroleum industry in the future than the developing economies.
That view was outlined in a recent report issued by the McKinsey Institute. The report suggests, according to Frank Holmes of U.S. Global Investors, China will account for one-third of the world's energy demand growth in the 2010-2020 period. McKinsey, employing what it believes are conservative global gross domestic product (GDP) growth estimates, projects that China's industrial sector will necessitate an incremental 28 quadrillion British thermal units (QBTUs) and its residential sector will need an additional 11.6 QBTUs. One QBTU is equal to 172 million barrels of oil.
In 2006, according to the International Energy Agency (IEA), China consumed 75 QBTUs and over the next decade its consumption will rise by 52.4 QBTUs, or nearly 70%. For the world, energy demand should rise by roughly 34% or 158.5 QBTUs compared to 2006's estimated consumption of 472 QBTUs. Within the world forecast, the United States should see a six QBTUs increase on 100 QBTUs of energy consumption in 2006. Of major energy consumers, Japan will experience only a 0.4 QBTU increase in the next decade, less than a 2% increase as its steel (-0.1 QBTU) and light duty vehicle (- 0.5 QBTU) businesses actually experience negative energy demand. McKinsey does say that improved energy efficiency could alter its forecast of demand growth and therefore its projections for specific country and industry energy demand estimates.
These forecasts point out the challenge confronting executives in the petroleum industry. Will the economic recovery that may or may not be underway but will be at some point in the near-future, be strong or weak? Possibly the recovery will be somewhere in between. In another article in this Musings we touch on the issue of the state of Americans' love affair with the automobile. Will we continue to build and buy new cars at the historic rates of the past, or will we need to settle for a significantly lower target? What types of new housing will
Americans buy -- slightly down-sized McMansions or the modest homes of the 1950s and 1960s? The answers to these questions will determine how America's energy demand will grow, and what fuels will be favored.
The questions posed above are important and relate primarily to the United States, but they also impact the economic future of the rest of the world's developed economies, especially those countries of Europe and Japan with aging populations. Demographics are the engine of economic and energy demand that are often overlooked by forecasters. Just how will China's economy evolve as it confronts a rapidly aging population with few younger workers to support them due to the decades-long government policy mandating one-child families?
A bigger question is how will American consumers evolve as the credit crisis and economic recession end? We can envision a future American economy that more resembles the 1950s than the 1960s or 1990s. It is possibly that just as the 1950s set the stage for a robust 1960s, which produced the longest post-war economic expansion until the 1990s, a decade-long consumer retrenchment could set the stage for a robust economic era beginning in 2020. On what basis might we assume this scenario?
If we consider the historical pattern of U.S. Government debt as a percentage of gross domestic product (GDP) since 1929 to 2010, the post-World War II period provides an interesting template for the future. During that period the older population felt lucky to be alive, having survived the 1930s and 1940s, and settled in to a time of saving, preservation of capital and lowered expectations as consumers. During the Eisenhower years, real progress was made
in reducing the high relative public debt levels of the war years and in planting the seeds for a new kind of consumption-based economy. Transistor radios, black-and-white and color televisions, new cars and new homes were all part of this new consumption economy. But as the shift in the composition of spending was underway, the Kennedy administration relaxed tax codes to stimulate the economy's growth, which set off a 106-month trough to peak expansion lasting from February 1961 to December 1969. As the economy expanded the composition of private/public sector debt was rebalanced and the weighting of GDP was altered with consumers ultimately accounting for 70% of domestic growth and 20% of international growth.
Today, we are undertaking another significant structural change in which public sector debt will account for a greater share of total debt. This shift has meant that it takes more debt to generate incremental dollars of U.S. national income. In fact, recently the ratio was up to $5 of new debt needed for $1 of incremental national income. The result of this shift is that the ratio of gross national debt to GDP will rise to 82.5% in 2010 from 55% about 20 years earlier. Only Japan (177%) and Italy (117%) today have higher debt burdens.
At the end of 2008, the average U.S. household debt to income ratio rose above 1.6. The Eurozone is about half that ratio. Aggregate U.S. public, corporate and consumer debt stood at $57 trillion or four times net income and is rising, largely driven by public debt. Current income tax revenues of $2.6 trillion won't support an additional $1.84 trillion in Federal debt. U.S. public debt held by non-resident foreigners is about 115% of GDP.
The net result of all this is that consumer spending had to drop and the savings rate had to rise. The issues are to what level; over what time period; and what will the impact be on consumption? Most likely we will have a Japanese-style deleveraging in which the debtto- income ratio is pushed down to 100% over the next 10 years. In a typical debt dynamics model, if we assume that the nominal interest rate on existing debt is 7%; the future growth rate of nominal disposable income in 5%; 80% of savings generated are used to pay down debt; then the household savings rate would need to rise from 4% to 10% by 2018. The impact of that savings increase would be to cut the consumption growth rate by three-quarters of one percent. That calculation is based on a normal savings rate model, but if the calculation is off a declining savings rate such as experienced in The implication of this model for future U.S. economic growth is considerably less consumer spending recent years, the reduction in the consumption growth rate would be greater. Real consumption growth rates remain negative and even in the last half of 2006 and in 2007, growth was in the 2%-3% range. That rate would fall with a higher personal savings rate.
The implication of this model for future U.S. economic growth is considerably less consumer spending. That will mean fewer cars, houses, appliances, vacations, computers and other electronic gadgets, along with other things consumed in the U.S. It also means that there will be a negative impact on manufacturing in many developing economies and reduced world trade. Many industries being forced to retrench now may face years of highly competitive commercial markets. For consumers, as the Rolling Stones put it, "You can't always get what you want." Inventories will be kept low meaning delivery times for goods will expand. Supplies of products will be limited, meaning re-orders may be non-existent. Operating margins will be sustained by managing inventories. Deflationary price discovery and distribution will dominate the economic landscape.
This environment we are describing may resemble the post-Korean War period when interest rates were low, large drops in GDP occurred as the economy struggled to shift from its war-driven to a consumer-driven mode. Inflation was generally low during this period except for some brief spikes due to demand/supply shocks. The stock market may trade in a range for many years as occurred in that period and during the 1970s, but as we near the end of the static period, the market could rise dramatically. The risk to this scenario is that the war underway between the public and private sectors results in the Federal government usurping larger and larger segments of the economy and turning the U.S. into a quasi-planned economy.
Another possible outcome from this public/private debt struggle is that the government decides to repudiate certain debt. While this would appear to be a low probability given the government's control over the money supply, there were several periods when American states repudiated their debt. The first occurred in the 1840s following the panics of 1837 and 1839, largely related to the inflationary boom caused by the Second Bank of the United States. As the deflationary period of the 1840s unfolded, nine of the 28 states repudiated some or all of their liabilities. The next wave of repudiation happened in the South after its occupation by the North following the Civil War. Eight southern states, under Democratic administrations, repudiated their debt during the 1870s and 1880s. The final American debt-repudiation occurred after the Spanish- American War. The U.S. repudiated the debt of Cuba after conquering the island as we claimed the debt was incurred by the Spanish government without the consent of the Cubans and was used to help finance oppression and therefore wasn't legitimate.
From the economic recovery scenario we have laid out, we can begin to build a model of what energy demand growth should look like and the implications for the petroleum industry. We will tackle that in our next issue of Musings.
G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.
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