Oil Scramble Ahead?
February 3, 2011
By John R. Taylor, Jr. Chief Investment Officer
Studying Italian history forty years ago I learned that the major reason behind the peninsula's decline from Renaissance greatness to its sickly position in the mid-19th century was its loss of economic advantage. Political chicanery and internecine wars played a lesser role to the opening of the Atlantic, which eliminated its dominance in international trade, and to Italy's lack of physical resources. No coal, no iron ore reserves, and no fast flowing rivers meant the industrial revolution passed the country by. According to this view of history, the leaders were overwhelmed by the forces of economic change. On the positive side, the Miracolo Economico, which brought prosperity to Italy after WWII, was driven by the discovery of major natural gas fields in the Po valley. With their coming exhaustion Italy could be slipping back to its old position as an also-ran.
Countries that control more of the factors of production will be dominant. Today, the tables seem to be turning on the West. As education has become almost universal, knowledge, intellectual expertise, and competent labor have become less expensive and less valuable as a result. With the economic distress in the developed world forcing a massive increase in global money, capital has become universally cheap. Developing countries that were starved for capital now must protect themselves from an overabundance. There is a distant parallel here with Renaissance Italy, as its banking, financial, and trading expertise became common throughout Western Europe, devaluing it; Italy's edge was gone. Today the western world is losing its advantage in knowledge, labor, and capital. With communication now global and historically inexpensive, more and more trade, and growth, does not have to pass through developed world ports or phone systems. Because the playing field has become level for the first time in history, we would argue that, at this time in history, the battle has shifted to raw materials. If we assume that today's critical resources are gas, oil, agricultural output, and rare earths, Europe is totally out in the cold and the US is supported only by its strength in food production. Although commodities have played a diminishing role in economic history and, thanks to scientific advances, should continue this long-term trend, the scramble for scarce resources should impact economic cycles and growth in the decades ahead.
It was less than three years ago that oil went to $140 per barrel and the commodity index climbed over 3 standard deviations and 60% above its 4-year average. An extreme like that should statistically occur about once every century, but despite dropping below the 4-year average for half of 2009, we are now about 2.7 standard deviations and 50% above it, and still climbing. This is a big surprise and a big problem for global prosperity. Now, the turmoil in Egypt has lifted the fear component in the oil price as well. Furthermore, a deep political rift between the US, as Israel's protector, and the newly democratic but primarily fundamental Egypt and its allies in the Islamic world is a distinct possibility. Saudi Arabia could come under pressure. The most negative near term result of this split would be OPEC's refusal to increase oil output, despite the rising price, something similar to the situation after the Yom Kippur War in 1973. Food, not oil, has been the primary focus of this recent inflation scare, and the trend of climbing prices actually seems to be accelerating. The tight supply status in many critical commodities, plus the recent weather foibles around the world, should keep this move intact until the global economy turns down, dropping demand. The increase in headline inflation should also turn the global economy down. Not only does the cost of food and fuel drop the demand for manufactured goods, clothing, and leisure activities, but it could convince the ECB and other central banks to raise interest rates.