#44. Britain through the looking glass

Starting with Greece this weekend, we could be at the beginning of a series of political earthquakes in Europe. One of these earthquakes might well occur in Britain, even though we have a political system designed to favour the status quo. What I’d like to do here is to discuss the UK outlook, bearing in mind that this has to be set in a broader European context.

Where the UK is concerned, an earthquake is desirable, primarily because our system of governance has become deeply faulted. As I shall explain, this has damaged not just our government but also our economy (which, by the way, is nowhere near as strong as we are led to believe).

First, though, let me deal with the Eurozone (EZ), because at least the problem here is a very simple one. The single currency doesn’t work, and indeed cannot work. This structural absurdity will continue to blight the politics and the economies of the EZ countries until one of two solutions is adopted. These two solutions are the “forwards” and “backwards” options – “forward”, that is, to full political integration, or “backward” to the unwinding of the Euro and the reintroduction of national currencies. One or other simply must happen, even it is hard to see either happening anytime soon.

Since the Euro was introduced, the competitiveness of the EZ countries has diverged. If we in Britain, with our own currency, were to suffer a loss of competitiveness, we would devalue, making imports more expensive and our exports more attractive to foreigners. (Incidentally, I think a big devaluation of Sterling is likely, but more of that another time).

Countries like Greece and Spain, however, cannot devalue in this conventional way. Instead, the only way in which their competitiveness can be restored is through an alternative, unconventional process of internal devaluation. Since Greece (for instance) no longer has a drachma to devalue, the only way she can restore competitiveness is to drive down local costs, which means cutting real wages, thereby reducing the effective international prices of Greek goods and services. Put as succinctly as possible, austerity has been imposed upon Greeks (and others) as the only form of devaluation available.

Despite what Harold Wilson famously and fatuously said about “the pound in your pocket”, conventional devaluation is painful – but internal devaluation is very much worse. Small wonder that Greeks despair of their established political parties.

If statistics are anything to go by, Britain is second only to Greece in the “political earthquake stakes” – Greece seems to be the only European country in which existing parties are held in greater disregard than they are in Britain. As things stand, Labour and the Conservatives will struggle to get 50% of the vote, and even the inclusion of the Liberal Democrats might not push the three parties’ combined vote much over this level.

A widespread public perception seems to be that all three are pretty much the same, despite differences of policy, emphasis and rhetoric. Fundamentally this view is surely right, as Labour, the Conservatives and the Liberal Democrats are different factions within the establishment, and the real divide in Britain is between those who accept the establishment and the increasing number of those who reject it.

Whilst I dislike historical metaphors, this situation is not too dissimilar to England in the seventeenth century. The English civil war had nothing to do either with democracy or with the common people, but was a falling out over religion, influence and wealth within the governing elite. After the execution (or, as I see it, the assassination) of Charles I in 1649, the Parliamentarians held power without effective opposition.

To be sure, there were many contesting factions within the Commonwealth, but their differences had little or no relevance to ordinary people as the Puritan fanatics set out to ban everything from theatres and pubs to country dancing whilst treating the public to a withering diet of political correctness, seventeen-century-style. No wonder there was widespread relief when the monarchy was restored.

Whilst it would not do to push the metaphor too far, the situation in Britain today has distinct echoes of the Commonwealth era. Major ideological differences within the governing elite ended as effectively in Britain in 1997 as they did in England in 1649.

As they showed with their concerted effort to buy off Scots voters at the last minute, all of the major parties have far more in common than they differ over. Beyond a shared taste for moralising – the modern equivalent of Puritanism – the main point of unity between the established parties is their acceptance of corporatism in preference either to socialism or to free market capitalism.

This is reflected in the conduct of the economy, where corporatism seems ever more influential in driving economic policy. Like any ideology, corporatism leads to a frequent rejection of common sense in favour of preferences which suit the ideology. Instead of strengthening competition within the private sector, where greater competition would improve both output and living standards, successive governments have preferred instead to introduce corporatist quasi-markets into the public sector. The reality, of course, is that, whilst many activities are best left to a competitive (not corporatist) private sector, others (such as the provision of healthcare, and arguably of housing too) can better de delivered by the state. In other words, a mixed economy is best.

Against this, of course, the established parties would point out that the British economy is out-growing its competitors, and that unemployment has fallen sharply. Though true, both need to be qualified. Unemployment has indeed fallen, but at the price of a general lowering of real wages to the point where the tax take still cannot meet the costs of the corporatist state.

Economic growth, meanwhile, remains something of a statistical phenomenon. GDP may have risen by a nominal £80bn last year, but the State alone is borrowing more than that (around £90bn), even before we include increases in mortgage and consumer debt.

More seriously, our current account imbalance has crashed to an annualised £100bn, which means that an unsustainable 6% of GDP now comes courtesy of foreign lenders and trade creditors (see chart).

UK BoP annualJAN 15

Successive current account deficits have been bridged by asset sales and borrowing from overseas, to the point where we have built-in a major (and increasing) net outflow of dividends and interest. Meanwhile, the State continues to spend more than the economy can afford.

When looking ahead to the election, of course, we need to bear in mind that our “first past the post” system biases the process in favour of the established parties. This said, the likeliest outcome seems to be that an electorate which cannot oust the established parties might visit upon them instead a chaotic imbalance, as the next best thing to outright rejection.

Bring on the earthquake.

#43. Oil – where next?

In my previous article, I discussed the collapse in oil prices, explaining that the greatest mystery wasn’t the price slump so much as the preceding resilience in the face of the growing bubble of surplus supply. Comparing 2014 with 2011, demand had increased by 2.9 million barrels per day (mmb/d) whilst supply other than OPEC crude had ballooned by 3.9 mmb/d, making the recent price correction not just inevitable but long overdue.

Here, I’d like to look ahead a bit, setting out what I think may lie ahead for oil markets. Before I do, though, it’s necessary to dip briefly into the past. During the 1973-74 “first oil crisis”, the price of crude shot up, averaging $11.58/b (about $56/b at today’s values) in 1974 compared with $2.48 (equivalent to about $14/b) in 1972.

Initially, there wasn’t much that anyone could do about this – demand dropped briefly but then began growing again, and there was no immediate surge in supply.

Scroll forward to 1980, however, and a lot had changed – demand had declined as new fuel-efficient vehicles reached the market in significant numbers, and non-OPEC production surged in response in huge investment in areas like the North Sea. Confusingly, the slump in demand coincided with the “second oil crisis”, which pushed the average price up to $36.83/b (say $106/b in today’s money), but it was the longer-term response to the first oil crisis that was really behind the sharp correction in the relationship between demand and supply. (OPEC tried, Canute-like, to prevent the inevitable, but their price support effort cracked open at the end of 1985).

The point of this history is that, whilst oil markets certainly do respond to changes in price, they can only do so slowly. When markets are severely over-supplied, as they are now, there is almost no price that is too low.

So, when oil markets reach “peak glut” – and they will be building in to that over the coming two or three months – it is by no means impossible for prices to fall even further than they already have. I’m not forecasting $25/b, but I certainly wouldn’t rule it out.

Conversely, when there is a shortage of supply, there is almost no price that will restore short-term equilibrium, which is what happened in 2007, when Brent crude topped out at nearly $150/b.

Critically, there is very little that consumers can do, in the short term, to respond to price volatility. Just because prices have slumped, it doesn’t follow that we’ll all start driving a lot more, or all go out and buy gas-guzzlers. Likewise, producers aren’t going to shut in huge quantities of production, because cash flow remains positive for any producer who can cover cash opex costs.

What will happen, however, is that capex will be slashed, with little impact on immediate supply but with game-changing implications a few years down the line.

The pinch-point in the system has to be shales. I’m not expecting much of a decline in output in the coming few months, but what I do expect is that capex will dry up, as shaleco bonds turn to junk, shaleco equities bomb and shaleco IPOs become toxic. The ending of the “drilling treadmill”, which was probably due to happen two or three years from now anyway, will come much sooner as the markets starve shale operators of investment.

This is where the shale industry’s scary decline rates kick in, when annual per-well output declines of as much as 60% are no longer offset by new drilling.

Earlier, I referred to the imbalance created by a supply increase of 3.9 mmb/d, compared with demand growth of 2.9 mmb/d, since 2011. Within that supply increase, non-conventional output from OPEC countries contributed 0.5 mmb/d (13% of the increase), but much the biggest contributor was US shale output, which accounted for 71% of all increases in non-OPEC supply between 2011 and 2014.

As its proponents will tell you, shale operating costs, though high, remain covered by oil prices as low as $50/b. What they will not tell you is that shale’s Achilles’ Heel is capital costs, which are ultra-high because of the “drilling treadmill”, which is the continuous need for new wells to offset the sharp declines from existing producers.

As things stand, the oil market is oversupplied by an annualised 1.0 mmb/d or so, but the pressure right now is much greater than that. Given the time required for transport, shipping and distribution, any oil bought after the end of November isn’t going to reach the end user until the winter demand peak is waning. By February, crude purchasing is likely to be at least 4 mmb/d lower than it was in November.

In other words, the world will be awash with oil this spring.

To correct the disequilibrium, we need rebalancing to the tune of between 1.0 and 1.5 mmb/d. That clearly isn’t going to happen this year. But, looking ahead to 2016, it is quite conceivable that demand will have increased by perhaps 1.3 mm/d, whilst all supply (other than OPEC quota crude) may have decreased by close to 1.0 mmb/d, restoring equilibrium (see table). There could be further gradual increases in the call on OPEC crude in subsequent years.

Oil supply and demand projections

Summarising all of this, if OPEC supplies 30 mmb/d of crude:

– The market will be oversupplied by as much as 4 mmb/d this month, and something similar in February, putting further severe downwards pressure on prices.

– But shortfalls could emerge during 2016, becoming progressively more pronounced after that.

In the past, an adjustment of this magnitude would have taken several years, a time-scale determined mainly by the relatively slow decline rates of conventional production sources in the absence of sufficient capital investment. This time, though, the quick-decline/high-capex nature of the shale business is likely to compress the process of adjustment.

With the markets heavily glutted, there is almost no limit to how far oil prices could fall in the coming months. A year or so on, however, a slump in shale output, combined with modest growth in demand, could have mopped up today’s excess oil and left us short of supply.

That’s when the fundamental reality – which is that the world’s oil supply slate goes on getting costlier to produce – will reassert itself.

FOOTNOTE

It may help readers if I insert here my estimates of monthly stock changes, in millions of barrels per day, with forward calculations based on OPEC crude supply of 30 mmb/d.

Red boxes indicate supply in excess of purchasing requirements, whilst blue boxes indicate a shortfall. As you can see, prices ought to have fallen sharply in early 2014, but didn’t. By the closing months of the year, however, the cumulative surplus was severe enough to combine with the current surplus to force prices lower.

After some grim opening months – which are likely to exacerbate the existing surplus – the outlook becomes progressively better.

monthly stock change