Plumbing the depths

OPEC has its work cut out to stop the oil price from sinking further

ENERGY analysts spent the first half of the year debating how expensive oil could get. Now they are asking the opposite question. On December 2nd the price of a barrel slipped below $47, the lowest level since May 2005 and less than a third of the peak reached in July.

The main reason for the slump is the darkening outlook for the world economy. Demand for oil continues to grow in a few spots, such as China. But in most places it is falling. America’s appetite for oil, for example, had been more or less stagnant for the past few years, but has recently dropped dramatically (see chart). Many now expect global oil demand to fall next year, and perhaps even this year—which would be the first decline since 1993. Meanwhile, several new oilfields and refineries, which were set in motion when the price seemed likely only to rise, are due to start up in the coming months, increasing supply just as demand atrophies.

The Organisation of the Petroleum Exporting Countries (OPEC) does not seem able to cut its production fast enough to keep pace with all this grim news. In October the cartel agreed to pump 1.5m fewer barrels each day from November 1st, reducing global supply by about 2%. But that cut is only just beginning to take effect, since it can take more than a month for tankers to reach their destinations. Moreover, OPEC’s members do not yet seem to be complying fully with their diminished quotas.

The king of Saudi Arabia recently said that $75 a barrel would be a fair price—an idea that other members of the cartel have echoed with enthusiasm. Oil’s plunge has left many of them in dire fiscal straits. This suggests that when the group meets again on December 17th, it will resolve to cut its production further. But Saudi Arabia will not want to bear all the cost, so it will insist that other big producers, such as Iran and Venezuela, should not only agree to further cuts of their own but also implement them.

Michael Lewis of Deutsche Bank argues that OPEC’s past efforts to prop up prices have succeeded more often than not. Since 1993, cuts in production have led to higher prices on three-quarters of occasions. The exceptions, however, have occurred when the world economy has slowed unexpectedly—most notably in 1998, after the Asian crisis, and in 2001, after the dotcom bubble burst. On those occasions, the price kept falling for more than six months after OPEC first began reducing its output. In 2001, for example, the cartel had to resort to a series of cuts, totalling 5m barrels, before the price finally began to recover.

If events take a similar turn this time, Mr Lewis reckons, OPEC will have to keep cutting its output for another year. The price may not hit rock bottom until early 2010. But the world economy looks less healthy now than it did in 2001, so OPEC may face even more of a struggle this time, he thinks. Deutsche Bank, for one, sees prices falling as low as $35 at times between now and then. After adjusting for inflation, Mr Lewis points out, that would only take the price back to its average level since 1972.

Dec 4th 2008
From The Economist print edition

The American economy

A spent force

Ominous signs that the crisis will have a big impact on spending

IT WAS, admitted Hank Paulson as he threw a $250 billion lifeline to American banks, objectionable to most Americans, himself included, to see the government owning stakes in private companies.

He had no real alternative. But it would have been less objectionable had he been able to promise that the economy would escape a recession as a result. He could not. It may well be in recession already.

The economy appears to have barely grown in the third quarter and the surge in financial stress that followed Lehman Brothers’ failure in mid-September will make things worse. The subsequent plunge in stocks on top of still-falling home prices could result in a 14% drop in household wealth this quarter, the largest on record, according to ISI Group, a broker. News that retail sales sank 1.2% in September triggered the biggest drop in the Dow industrials in 21 years on October 15th.

If it were only wealth, construction and other tangible factors that were in decline, the recession could still be on the mild side—especially as oil prices are falling. But the credit crunch is a wild card. The experience of the Carter era suggests the effect of credit restraint can be large. In 1980 President Jimmy Carter imposed credit controls in a ham-fisted effort to reduce inflation: banks that exceeded targets for some types of loans such as for consumer purchases and mergers had to set aside extra reserves. Americans overreacted in a burst of patriotic fervour; credit usage plunged and GDP fell by an annualised 8%, the steepest quarterly drop in the past 50 years.

Since then the influence of debt has probably grown as the economy has become more credit-intensive. Consumer and home-equity loans equalled 26% of annual personal consumption in the 1990s; they recently reached 36%. In the 1980s about half of homeowners had a mortgage; now about two-thirds do, says Ivy Zelman, a housing consultant.

Meanwhile, the demand for bank credit by companies shut out of the commercial-paper market is straining balance-sheet capacity. In theory the government’s $250 billion rescue package for banks, levered ten-to-one, could support $2.5 trillion of lending (total credit in the economy was $27 trillion as of June 30th). But no one expects so large an effect because banks are trying to delever and will probably build their reserves in anticipation of more loan losses as the economy worsens.

Non-banks are a particular problem. The finance affiliates of the big carmakers, most prominently GMAC, 49% owned by General Motors, now face funding constraints, forcing them to raise underwriting standards and loan charges. Approvals for car-loan applications have fallen sharply (see chart).

Non-banks can tap the Federal Reserve’s new commercial-paper guarantee programme, but are not eligible for government capital. Credit-card debt continues to grow but in that business, too, lenders are cracking down in subtle ways, says David Robertson of the Nilson Report, an industry newsletter. One is to reduce unused credit limits on middle-to-higher-income borrowers who might use more credit if they lose their jobs.

Surprisingly, mortgage-lending conditions may be improving. Under pressure from the federal government, Fannie Mae and Freddie Mac, the now-nationalised mortgage agencies, and the Federal Housing Administration, the programme for low-income buyers, are stepping up their activity. A buyer can now obtain an FHA loan with as little as 3.5% down on a house costing up to $625,000—which would include most of the homes in the country. Ms Zelman reckons the FHA accounted for 22% of mortgage originations in the third quarter, up from 5% in all of 2007.

The real problem, Ms Zelman says, is that almost a quarter of homeowners with mortgages have zero or negative equity in their homes. Householders, she says, have too much debt and must save more. It is, she says, not about credit. “It’s about a hangover from hell.”

taken from:

Oct 16th 2008 | WASHINGTON, DC
From The Economist print edition