Cezary Salad

For anyone interested in emerging markets, the mot juste all of last year was the d-word: “decoupling”. In a nutshell, it’s the theory that emerging economies have gained enough critical mass to chart their own path to growth and prosperity independently of the developed economies in Europe and North America. In other words, a recession here shouldn’t automatically translate to a recession there.

In 2008, the concept became so controversial among economists that one could even catch the venerable Economist weighing-in on both sides of the debate (“Decoupling is not a myth” – March 6, 2008 print edition; “So much for decoupling” – 18 September, 2008 print edition).

This week, Newsweek’s international editor, Fareed Zakaria joined the fray. Zakaria, an astute observer of foreign affairs, argued in his June 8 Newsweek column (“Boom Times Are Back - Just not here in the United States”) that the global economy is increasingly going to become a tale of two worlds. In one camp, there will be the booming, hard-charging emerging economies like China, Indonesia, India and Brazil and in the other the lagging bastions of wealth and power like the US, Europe and Japan (unless, of course, the latter undertake drastic reforms to alter this inevitable fate).

For regular followers of Zakaria, this, of course, is nothing new; his bestseller, The Post American World, is an exposition on this very same paradigm. And he made the same point last year in an article for his previous employer, Foreign Affairs magazine.

But one paragraph caught my attention since, without naming the controversial d-word, Zakaria seemed to use it as a way to justify the tale of two worlds:

Over the past six months, much conventional wisdom about the economy has been discredited. The old experts who spoke with confidence about unending global growth—the boomsters—have been debunked. But the new pundits of pessimism—the doomsters—have demonstrated a similar hubris, ignoring any evidence that might complicate their story. Six months ago, stock markets around the world swooned in unison as the American financial system seemed on the verge of collapse. This led many to conclude that the emerging economies of Asia and Latin America had been growing only because of their exports to America and Europe; that they obviously had no independent strengths of their own and would in all likelihood collapse faster and more furiously than the sophisticated economies of the West. After all, these were Third World countries.

Not exactly. Zakaria’s got the big picture right – there is indeed a growing rift between these two worlds – but he oversimplifies the details of how this fits in vis-à-vis decoupling.

First, one ought to take a longer reference point than the last six months. After the credit markets exploded in August 2007, emerging markets were one of the first places investors went with their displaced capital. So then, like now, as markets peaked here in the US and in Europe, they continued to hum along in places like Brazil, Russia and China.

Then, of course, came the big crash in January 2008, when markets tumbled all around the world and the Federal Reserve made its emergency 75 basis point cut to stem a similar panic here in the US before markets opened on Tuesday, January 22, 2008. It’s that episode, much more than the post-Lehman collapse roller-coaster, that’s ground zero for any debunking. We saw then these “new pundits of pessimism” argue that the emerging economies would follow the US into recession and the “old experts” appeared debunked. Now, thanks to the recent bull market, it seems the opposite is true.

This, of course, sits well with Zakaria’s tale of two worlds. He cites China’s Shanghai index (up 45 percent this year), India’s Sensex (44 percent), Brazil’s Bovespa (38 percent) and Indonesia’s index (up 32 percent) as evidence of this debunking.

But it is more helpful instead to look at peaks and troughs. US markets (as measured by the S&P 500 Index), peaked in October 2007 and bottomed in March 2009. Stocks are a leading indicator, so this means that investors thought the US would enter recession around 1Q 08 and re-emerge sometime this year.

China’s Shanghai index likewise peaked in October 2007, but it troughed earlier – November 2007. India’s Sensex peaked in January 2008 and troughed in March 2009. Brazil’s Bovespa fared better, peaking in May 2008 and troughed in October 2008 (see chart below – interactive version is available here. Indexes are rebased to August 2007 and presented on a logarithmic scale; I left Indonesia out since I don’t know which index Zakaria was referring to in Jakarta).

What’s remarkable about this portrait is that all of these economies seem to have followed the US into recessionary bear markets, peaking after the S&P and recovering before or as it recovered. This begs the question: did these and other emerging countries begin to recover because of their own, innate strength or because investors saw recovery on the horizon in the US and other developing markets?

I certainly don’t claim to have an answer to this question and, as Zakaria wisely points out, stock markets don’t tell the whole story. But it just goes to show that this whole debate is a lot deeper and more complicated than he makes it out to be in his column.

In the long run, though, he certainly has a point: China, Brazil, Indonesia and other emerging economies are certainly in a better fiscal shape than the US and Europe right now and are poised to grab a larger share of the world’s wealth and power in the coming decades.

But how they get there and who follows who is far less clear than the black-and-white tale of two worlds.

One of my readers - Morgan Oliviero from New Brunswick, Canada - recently commented on my three-part series on oil prices:

To the extent that energy is considered in many countries to be a national security interest, and thus to be heavily regulated, how does governmental interference affect the way that oil prices have been climbing?

Good question, and something well-worth considering given the current clamor from Democrats, including Sen. Obama, for an “excessive profits tax” to be levied on American oil companies.

Government interference in markets comes in two basic flavors: subsidies and taxes (spicy or mild, respectively). Both can have a significant impact on a market, though in opposite directions. Subsidies, by virtue of lowering prices, will have an upward impact on demand and incentivize suppliers to produce more to meet that demand. Taxes, by virtue of raising prices, will have a downward impact on demand and incentivize suppliers to produce less to match that decrease in demand.

How has this played out in the oil markets? Oil is traded on a global market, so energy policies in large world economies can have a marked impact on the price we pay for it in the U.S. And unfortunately, developing countries - particularly Mexico, Malaysia, India and China - heavily subsidize energy prices in an effort to keep inflation low and spur growth. Naturally, this drives demand up and decreases the incentive for oil consumers in those countries to conserve or replace their fuel consumption with greener alternatives. And that, in turn, offsets the demand destruction that we’ve been witnessing in the U.S. over the last year, making oil prices “sticky” on the way down. As Keith Bradsher of the New York Times pointed out in this well-written piece on the subject:

The oil company BP, known for thorough statistical analysis of energy markets, estimates that countries with subsidies accounted for 96 percent of the world’s increase in oil use last year — growth that has helped drive prices to record levels.

Other numbers in Bradsher’s piece are equally frightening: China devoted $40 billion to oil subsidies this year alone, Indonesia followed with $20 billion, and Malaysia - before it raised gasoline prices by 40% earlier this summer - was spending 7.5% of its GDP on oil subsidies.

How big are these numbers relative to global spend on oil? Doing some back-of-the-envelope calculations, the U.S. consumes about 20.7 million barrels of oil per day (2007 figure), which at oil’s current $114/barrel price tag comes to about $2.4 billion/day, or about a quarter of the world’s total daily spend (all these figures, and many more, are available on the EIA’s petroleum statistics page). So hundreds of billions of oil subsidies a year from developing countries are not just a drop in the bucket: a significant amount of the world’s daily spending on petroleum is subsidized, and hence insulated to some extent from the rising oil prices.

The U.S., of course, is not so insulated and hence we’ve been paying the price for rising demand in developing countries that subsidize gas prices. This is not to say that the U.S. doesn’t give out its own subsidies to the oil industry in the form of tax breaks, but that is far different from wholesale price controls on gas prices.

But despite Washington D.C.’s increasing pressure on developing countries to lower or discontinue their massive subsidies for oil prices, doing so is not so simple. Consumers who have grown accustomed to paying low prices won’t give up that right without protests or anger at the politicians who dare take it away. As Bradsher points out, the Malaysian government faced public anger and outcry when it raised the price of gasoline by 40%. So don’t expect these subsidies to go away anytime soon.

What can the U.S. do? Again, the only long-term solution to this problem is for the U.S. to decrease its reliance on petroleum and switch to home-grown alternative energy sources: all the more reason why the Pickens Plan stands out as a painful thorn in the side of Republican cries of “drill, drill, drill.”

Moving to the tax side of the equation, taxes on oil consumption have had the opposite impact and, as expected, the bigger the tax, the bigger the drop in demand for oil. But here it is important to consider at what level the taxes are being levied: the producers or the consumers. Taxes aimed at producers tend to decrease their incentive to produce more since they get less of a reward for their investment; taxes aimed at producers will tend to decrease demand when prices rise. One decreases supply, the other demand. Either way, consumption falls.

But it is important to consider these effects in concert with other market conditions. If oil prices are skyrocketing to record highs and demand abroad - thanks in part to the subsidies discussed earlier - shows no sign of abating, then oil producers have little incentive to cut back on their production just because they may be forced to pay a higher marginal tax rate on their output. In other words, the incentive to produce less as a result of higher taxes is outweighed by the incentive to produce more as a result of soaring prices and growing demand.

A perfect example of this is the situation with Canada’s Tar Sands - a lucrative source of petroleum in Canada’s Alberta province that ranks among the biggest oil reserves in the world. As Morgan points out:

Oil producers in Canada’s Tar sands have been preparing themselves for a potentially punitive redistributive carbon tax that the Liberal Party has vowed to implement should it take power . . . Aside from forcing the producing corporations to prepare for significantly increased overhead, fund managers on Bay Street have been understandably concerned that this new tax could significantly damage profits, and therefore share prices.

However, for the time being, those worries seem to be outweighed by the huge potential for greater profits from increasing oil exports in the current environment of sky-high prices and increasing demand abroad. As the AP reported last month, Canada’s TransCanada Corp. and Texas’s ConocoPhillips announced that they will spend $7 billion to nearly double the amount of oil flowing from Canada’s Tar Sands to the U.S. Gulf Coast. So rest assured, Morgan - Canada will remain the U.S. top oil exporter to the U.S. in the near future.

This implies, though, that now would be a great time to raise taxes for oil companies since their business is so profitable that they’d probably be willing to cough it up. After all, as Sen. Obama is fond of saying on the stump, ExxonMobil took home nearly $12 billion in profit last quarter. Hence the argument for a “windfall profits tax” or “excessive profits tax” that would clip the wings of their soaring profits and hand some of this money - which didn’t result from any technological innovations or greater efficiencies on the part of oil companies - back into the hands of ordinary Americans who made it possible.

But this ignores one obvious fact about the global oil industry: it is dominated by global, multi-national firms that don’t have an allegiance to any one tax code. They can just fold up their headquarters and move their tax burden elsewhere, in which case the U.S. would be worse off than it was before. More to the point, though, the flimsy concept of “windfall” or “excessive” profits is so subjective that it is likely to leave many in the business community wondering what defines “excessive” profits and whether they’re next in line for getting a haircut on their earnings from Uncle Sam. In other words, there has to be a better way.

Again, though, the better way involves hard choices and sacrifices that America as yet doesn’t seem prepared to accept. Investment in green technologies like wind and solar energy, electric and hybrid cars and just plain old conservation are not yet considered mainstream ideas on Main Street or in Congress.

Luckily, though on Wall Street - with many investment banks and private equity firms devoting talent and resources to capturing profits in green energy - the idea is catching on. And so if it is distortion of the markets from public funds that is making the oil crisis worse, it may well be private pockets that, in the end, help make it better.

This is part two of a three-part series of posts reflecting on what’s really driving the price of oil in today’s markets. Thursday’s post focused on the role of dollar depreciation. Today’s post will focus on the tightening outlook for global supply and demand.

The outlook for diminishing supply combined with surging global demand for oil is probably the best-documented of the three long-term trends that are driving up oil prices - the other two being the depreciating dollar, which I wrote about on Thursday, and speculation, which I will write about in a future post. It is also the explanation most favored by everyone from the business press to regulators and talking heads on CNBC.

However, there is reason to believe that its impact on current oil prices is not as powerful as everyone believes. True, expectations of higher demand and lower supply do add upward pressure on futures prices and, in turn, spot prices today. But since longer-term supply and demand expectations regarding China and India are “old news,” they are to a great extent already priced into the market and thus cannot by themselves trigger an oil shock of the magnitude we are seeing now.

Hard truths

Let’s start with the facts. As the Energy Information Administration (EIA) detailed in its latest short-term energy outlook, world consumption of oil is continuing to grow despite 7 years of conscutive increases in oil prices, with decreases in demand from the U.S. being more-than offset by increases from places like China and the Middle East. Meanwhile, the pace of supply growth in non-OPEC countries is expected to continue to fall short of expectations and consumption growth - as it has in years past - thanks to faster declines in older oil fields and delays in expansion projects.

[For more information on these fundamental trends, check out the EIA's slideshow, "Next Stop for Oil Prices: $100 or $150," available here. Hint: it was written by economists, so the answer, of course, is "it depends."]

No one denies that these are the cold, hard facts on the ground (or rather, underneath). But what is of interest is how these longer-term realities impact prices today and where the rational limits of that impact lie. It is here that the plot thickens.

High expectations

The answer to the first question can be found in the role that expectations play in the oil market. As supply and demand conditions get more and more attention in the business press, sellers of oil have more reason to expect that they can capture a better price tomorrow than today and are therefore more likely to hold on to the marginal barrel of oil for sale at a future date. As a result, we’ve seen a steady upward revision in sellers’ future price expectations. For example, the price of crude oil for delivery in 2011 has more than doubled since January 2007, rising to $120 in May 2008, as economist Stephen P.A. Brown of the Federal Reserve Bank of Dallas illustrates in this chart from his article, “Crude Awakening:”

But how does a rise in futures prices impact spot prices today? As with many financial instruments, oil is priced over a benchmark - similar to a loan being quoted as LIBOR plus a credit spread. In the past, this benchmark used to be based on spot prices for certain crudes, such as West Texas Intermediate (WTI) or dated Brent. However, as this somewhat technical, but clearly-written and well-sourced post from the blog “Peak Oil Debunked” explains, since the mid-1980s, the oil industry has gradually shifted away from spot benchmarks to benchmarks based on futures prices because the former are easier to manipulate and corner than the latter. So when you see oil prices surging higher, what you’re seeing is a price formula that reflects changes in a weighted average of futures contracts for certain “benchmark” crudes (the WTI benchmark for U.S. oil, the Brent benchmark for oil sold by the Middle East to Europe, the Dubai-Oman benchmark for Middle East oil) plus a premium or minus a discount. Thus, higher futures prices lead to higher spot prices today.

This is why the venerable Economist was wrong when it argued in its July 3rd edition that futures contracts are simply “bets on which way the oil price will move” that “do not affect the price of oil any more than bets on a football match affect the result.” If football games were won by taking a weighted average of expectations over which team will win and then adding or subtracting some points for actual team performance, then the analogy would be apt. But since oil futures act as the benchmark for spot prices and therefore directly impact their levels, it is not.

So it’s clear that the bleak global supply and demand outlook is helping drive oil prices higher; here there is no bone to pick with analysts, the business press and talking heads. Instead, there is only the caveat that this is happening because of the way oil is priced over futures benchmarks - not spot prices.

Old news

Still, there is a hard limit as to how big the impact of this upward pricing pressure can be. That’s because none of the bleak macro supply and demand projections are news to investors. That is, it’s not as if late last year the world all of a sudden realized that India and China have very large and rising energy needs. We’ve known about this for years and it’s been priced into the markets for years. And at the end of the day, markets react to new information, not old news. Thus, unexpected announcements of buildups in oil inventories will move the needle one way or the other, but having a talking head on TV say that demand from China and India is growing doesn’t add any new information that hasn’t already been priced into the market.

Hence, the same old story of rising demand from India and China couldn’t by itself trigger such a precipitous rise in prices: it needed a spark. And that spark - as with the depreciating dollar and (as I will argue in a future post) speculation - came from the onset of the credit crunch. After the debt markets shut down last summer, billions of dollars that couldn’t be invested in debt securities went looking for a safe haven, which they found in the commodities markets. As I will explain in a future post on the role of speculators, this had an upward impact on the price of futures contracts and - via the same pricing formula desribed above - on spot prices. And once this happened, everyone from the business press to Treasury Secretary Hank Paulson and the EIA reiterated the tight supply and demand picture, which only exacerbated the panic and reinforced expectations of higher oil prices in the future.

This suggests that supply and demand forces aren’t as powerful here as one might think. This becomes even more evident when we consider the fact that the bleak global supply and demand outlook is a longer-term macro trend which stays pretty constant over time. That is, we know that China and India are probably going to be consuming more oil over the next few years and that supplies in non-OPEC countries will likely not keep pace with demand. But consider the fact that between the beginning of March and the middle of June nothing much changed in this fundamental supply and demand picture while the price of oil nevertheless jumped nearly $40/barrel over the same period. To say that this jump was all due to fundamental demand from India and China and tight supply in non-OPEC countries would be like explaining a particularly hot summer day by referencing global warming. Point being: it’s a long-term trend whose explanatory power diminishes as we focus on short-term oil shocks rather than gradual price increases over longer periods of time.

So yes - tight oil supply and real growing demand are powerful forces and serious problems that need to be dealt with. But their impact on the price of oil likely takes a passenger seat to the depreciating dollar and - as I will argue in my next post - the impact of speculators.