Let us make two assumptions. There’s enough oil in the world for now. And oil supply won’t respond to a rising price, not even a stratospheric one. Indeed be ready for perverse responses (a DECLINE in oil supply?).

The first of these assumptions is blasphemous, at least in some eyes. Yet there is forty years of global oil reserves at current pumping speeds, and this has been so for forty years.

In others words, in recent decades the world has been adding as much to its known reserves as what it has used up. Needless to say, this need not carry on forever, so the peak oil crowd is ultimately right, even if there can be argument about timing, be it short or long.

What matters is that this year or next or the one thereafter there won’t be a physical shortfall of oil, unless someone or something decides to take out a critical oil producer or two.

But barring that, there is enough physical oil in the world. Funny, for if that’s so, how did we get to $140?

The second proposition flies in the face of everyday economics, yet our global realities are making it happen, at least in the short-term. It is also by far the more important reality for now.

Why is global oil supply capacity hugging global demand like a second skin? Why don’t we see much more action in the oil patch, with oil at $140?

Don’t be too critical. The global rig count is well up at over 3000 now and rising, not quite the record 6000 of the early 1980s, but give them time.

Still, it doesn’t seem to matter all that much. Non-Opec for technical and other reasons just isn’t adding much new capacity, the great disappointment of the decade. Biofuels (substitute alternatives) is going great guns, in the process completely upsetting the global agricultural patch, but its quantities aren’t close to making a real splash on the oil patch.

That leaves Opec, with just over 40 percent global market share, and it is acting like an ageing monopolist (growing fat, lazy and rich). They call it resource nationalism, not investing more and not pumping more even when you can.

But it gets worse. Libya just announced reducing oil output. They are making more money than what they know what to do with. Why not produce less? Keep something for a rainy day? In the desert that can make a lot of sense.

The Saudis recently offered the world an olive branch. You know, kind of wanting to pacify the angry crowd, offering to produce 200 000bd more.

Stick it where it hurts, please

Nice gesture, guys. Firstly, it is heavy crude, for which there is oversupply and no demand, so stick it where it hurts, please. Secondly, it is your pumping CAPACITY that is at issue.

The problem in the oil world today is that the safety buffer between demand and supply is too small, only 2mbd. Why is that a problem? Well, any one of the top ten producers running into a production problem would wipe out the safety margin and create an oil shortfall.

Much more likely, problems affecting various producers simultaneously would do the same thing.

And even if the Saudis were to pump 200 000bd more as promised, this would reduce the global safety buffer by like amount to 1.8mbd. There’s currently nothing worse then doing precisely that.

So nice gesture, guys. But try again, like putting a few more holes down, and not dry ones either, please.

World markets can’t live with the bad odds and uncertainties and their implications of a global safety buffer of only 2mbd. They want safety in the oil patch, a reserve buffer of at least 5mbd. Even if something big then happens, it probably wouldn’t create a physical shortfall and the global mayhem this could cause.

And thus the global markets remain pre-emptively pushing for vigorous price discovery, pushing oil prices ever higher, looking for a change in the global demand/supply balance big enough to satisfy their risk considerations.

Only the adjustment won’t come from the supply side, at least not quickly.

That leaves demand.

World markets are seeking oil demand destruction. So far they have achieved some, but not enough.

Putting the US economy two percent into recession might do the trick, sundering its oil demand sufficiently to open up the global demand/supply gap.

This suggestion comes with one small proviso, namely that these lovely Opec brethren don’t then actually cut their oil supply. Yet they would at present supply levels and export earnings be quite capable of doing just that, thereby keeping the demand/supply balance still too tight and global markets continuing in price discovery.

Never mind Opec. Would Fed chairperson Bernanke be willing to put the US economy two percent under water in order to break spiraling oil prices and save the world?

Until recently that must have come like a particularly funny suggestion. You want me to do what? In recent weeks, however, there has been evidence that the Fed is getting sucked in, but apparently so far only to the extent of wanting to limit dollar weakness as commodity booster. But apparently this is to be achieved without for now actually raising US rates, for its weak economy simply couldn’t stand it. That’s quite a talking act.

Over in Europe, ECB President Trichet is perhaps a little less unwilling to respond to such suggestions, poised to raise interest rates this week by 0.25 percent, thereby undoing Bernanke’s talking act, and probably undermining the dollar anew.

Over in the East, they would have to slow their growth by two to three percent to achieve a similar impact. They are slowing their growth already, but so far it isn’t much. And they are chipping away at the protective cocoon around their oil consumers.

But all of this probably needs to go a lot deeper. Asians need to appreciate their currencies, slow their economies, strip consumers of their protective subsidies.

Yeah, sure, anytime, be my guest while you explain it to my four-billion population and reap the consequences.

But then what is worse for such populations in the long-term, the immediate real income loss or the gathering inflation storm?

So what have we got here?

So far, I would typify it as active global price discovery and a searching for involuntary global demand capitulation.

In other words, the oil price will keep rising until global demand ‘breaks’, well beyond Opec’s ability to cut its output to neutralize the demand adjustment.

Adding all that up could mean that the US might have to go into recession deeper than two percent, and the East may have to lose a few more growth percentages before the happy moment of oil price collapse finally dawns.

But the Fed is very much aware of its mandate, which keeps growth implications closely in mind, while the US economy is actually officially refusing to go into recession, still growing by one percent in 1Q2008 and the estimates for 2Q2008 now being two percent growth.

The source of this US growth? Help from tax rebates ($150bn), foreign demand (exports) and lean inventories. Housing construction and passenger cars are declining heavily, but contribute only seven percent of GDP and three percent of payroll employment. The remaining 93 percent of the US economy grew by 2.6 percent in 1H2008.

As to the Fed raising interest rates soon ‘to fight inflation’, there aren’t many people betting the ranch on that yet, not in August, possibly not this year, and possibly not until past mid-2009.

Until November the US is in electioneering mode, a sacred time. The fiscal tax boost is about to end, the rising commodity prices are in any case eroding consumer real incomes, house prices are still falling merrily, the credit crisis seems to be entering yet another critical period. Recovery seems far down the road.

Give the failing beast another kick in the pants

Indeed, there could be relapse, and that is traditionally a reason for the Fed to go to the rescue, not to give the failing beast another kick in the pants in order to break the global commodity impasse.

Or at least that has so far been the reality. Bernanke may yet make history by doing things differently, or in his stead Trichet may turn heroic, or all those Asians will rush over the precipice. But don’t hold your breath.

Token stuff there will be, like Trichet’s 0.25 percent rate increase in July, and the piecemeal subsidy reduction and currency appreciation in Asia. But that will stay marginal stuff compared to what is likely to be needed.

As a consequence, my sense is that global oil price discovery will continue, by brute force pushing these various oil consuming regions beyond where they want to be, with their growth underperforming beyond expectation, and their oil demand finally falling by more than what Opec can afford to cut output.

So how high will the oil price need to rise these next 12-18 months to achieve this result, for the long-term conservation and substitution effects will take far too long to arrive to be of any use shortly, and global markets will want their answer now, in real time?

Difficult to put a precise number and timeline to it, but it could really become bad out there for a while. It is putting many emerging central banks in an unfavourable spot, pushed as they are to address rising inflation by raising interest rates. It is all part of ultimately triggering the oil demand adjustment globally.

By the time this finally happens, I expect us to be deep in recession, despite such wonderful windfall anchors as agriculture and mining, and such recession-proof features as infrastructure-related construction and the public sector generally.

Starting this October, traditionally our most beautiful spring month according to the old poets who know about these things, the SARB’s leading indicator will be exactly twelve months sinking, the traditional moment at which we tend to enter recession.

After that it could be downhill for a while as this global thing does its worst. Indeed, we must hope for a quick end, not a drawn out one, for in what condition are we to experience a long and deepening recession, entering our own election by April next year?

Serious stuff, being strapped over a barrel.

Cees Bruggemans is chief economist of First National Bank.


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