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Gaddafi, Libya, and the Price of Oil

March 29, 2011

With the current political unrest in the Middle East and North Africa, the price of a barrel of oil has spiked. This has led a whole bunch of inflationistas (the newest and trendiest fashion out this year) to cry afoul about all sorts of economic policies, justifying their claims by mentioning economic theories that they don’t understand.  In the hopes of clarifying the debate a bit, this post will discuss the root economic causes of the current rise in oil prices.

To understand the current burgeoning oil crisis, I had to do a bit of research into regional politics. It’s not that I don’t follow history or current events, but as an economist I am more attuned to thinking about the economy. As such, I needed a refresher. Enter Gaddafi, the most flamboyant James-Bond style dictator still left standing.

Here is a man who understands the game. Born a lowly bedouin, he came to power in a military coup, and has since remained in power for more than 40 years; despite, having the audacity to bring down a passenger airplane in an act of terror. He relinquished Libya’s nuclear weapons program, and up until this point has successfully maintained his dictatorship through negotiations and concessions with Western-powers.

To understand the economics of 2011’s rising oil prices requires understanding the Middle East and North Africa’s economies and geo-political history:

Analysis

Muammar Gaddafi’s regime is a typical representation of the old Middle-Eastern, North African power structure, led by an atypical goon. The typical regional “oil-ligarch” power structure courts favors with the Americans and Europeans, trading oil and regional support for money and weapons. It is a fallout from the Cold War power-plays in the region. When Egypt attacked Israel you saw Russian military hardware and interests going against American hardware and interests. After the Cold War competition for influence in the region fell, yet with the rise of Russia and China’s economies the 2010 decade is seeing a renewal in regional tensions.

What has occurred in the region is massive protests, fueled by rising inequality caused by globalization and rising oil prices. This has led to the overthrow of regimes, once backed by the United States and Europe, and drastically increased the regional uncertainty. As I mentioned in this post, uncertainty regarding the expectation of future prices is a key driver in moving current prices up. Worse, it also serves to create a feedback effect whereby increasing prices resulting from uncertainty increase uncertainty about future prices. Now wait, some of you may say… Libya only accounts for 2% of global oil supply and even though its oil is better quality this still only accounts for about $3 a barrel price difference. You would be correct. But of course you’re missing the point. The story isn’t about Libya. It’s about that deva of a dictator Muammar Gaddafi.

Muammar Gaddafi, the most outlandish dictator in the region, was not the first to fall. Saner leaders in Egypt and Tunisia have already been deposed, with others throughout the Arab world looking like they might follow. Muammar Gaddafi is not particularly different from many of these despots in the level of brutality he is willing to bring against his own people. There have been reports of shootings in Bahrain and Yemen, both backers of the U.S. military. The truth is, for all the games the two have played, Western powers just don’t like Gaddafi that much and so are happy to see him fall. The West just wants to make sure its backing the winners of the region.

But what about those regional dictators who have done a better job courting the U.S. ? And what about the giant elephant in the room, Saudi Arabia? It has some of the highest inequality in the Arab world and a significant level of discontent and anti-American sentiment. A populous rebellion in Saudi Arabia would be disastrous for Western-powers and Western oil prices. In Saudi Arabia, and many other Middle-Eastern countries a U.S.A. friendly dictatorship is preferable to a popular revolt, and as the movement towards democracy progresses it increases the chances of a Saudi revolution and is already leading to revolutions in many of the other smaller countries the U.S.A. and Europe rely on to promote their interests in the region.

Remember from the Risk Premium Model, what matters are expectations, and these are based on the chances of future events. All that is necessary to drive up oil prices is the possibility that regimes backed by the West are overthrown and regimes hostile after decades of NATO interference emerge more likely to do business with China. This seems like a very real possibility for many countries regionally.

After all, it all comes down to oil and perhaps China, as foreign policy writer Conn Hallinan reminds us:

So what’s it all about? Okay, here is the cynical joke: “Is it all about oil? Nope. Some of it is about natural gas.”

Too simplistic? Maybe, but consider the following.

1) In 2009, the U.S. Energy Information Administration predicted that world oil reserves had “peaked” and that over the next several decades supplies would drop and prices would rise. There is some controversy over the study, but there is general agreement that easy-to-get petroleum sources are getting harder and harder to find.

2) Approximately 65 percent of the world’s remaining oil reserves are in the Middle East, as well as considerable amounts of natural gas. Iran has the second greatest reserves of gas outside of Russia.

3) The U.S.—with the largest economy in the world—uses around 21 million barrels of oil per day (bpd). Since it produces only 7.5 million bpd domestically, it imports two thirds of its oil. Its major sources are (in descending order) Canada, Mexico, Saudi Arabia, Nigeria, Venezuela, and Iraq.

4) China—the world’s number two economy—uses about 8 million bpd, a demand that is projected to rise to 11.3 million bpd by 2015. Since it only produces 3.7 million bpd domestically, it too relies on imported oil. It main suppliers are (in descending order) Saudi Arabia, Iran, Angola, Russia, Oman and Sudan.

So what does this all mean? Inflationistas would tell you that is a sure sign of the coming inflation. I will tell you this, what is happening currently with regards to oil prices is not due to inflation. In 2009, both Goldman Sacks and Nouriel Roubini predicted oil should be in the 30-40$ range per barrel, it’s currently at $115 a barrel and I don’t think the economy has picked up to the extent where it justifies current prices… do you? I didn’t think so.  What has changed is not the global economy, but global possibilities and expectations. No one knows what the future price of oil should or will be, but if regimes change there is the possibility and expectation that they may well not want to keep selling oil to countries they don’t like at the current rate. And as previously mentioned, in the future they may be able to find a sufficient number of potential buyers outside of the Western-sphere.

Economist Nouriel Roubini has stated that the price per barrel of oil that might lead to a double dip recession is somewhere around $140 per barrel. This seems reasonable to me, considering that in 2008 it was around that price and even then it was hard for the economy to bear. However, Roubini also thinks that even at that price range there won’t be inflationary consequences, here is why:

Oil prices at their current levels probably won’t lead to a “significant” acceleration in inflation in advanced economies because they are recovering from a “severe recession” and still face high unemployment, Roubini, 52, told a conference on hedge funds in the Persian Gulf emirate earlier today.

“Workers don’t have much wage-bargaining power,” he said.

Still, Roubini said job creation this year in the U.S., the world’s biggest economy, is going to be “barely enough to satisfy the increase in labor supply.”

With unemployment keeping core inflation in check, raising interest rates in some advanced economies too soon would be a mistake, Roubini said.

Basically wages will keep core prices down even as the price of oil inflates (note dear inflationistas that the price of oil can only inflate so much until demand suffers).

Note, what follows is a prediction regarding the next few years:

I think that it is likely we will see oil prices continue to rise or remain high in the short-term until things in and around the oil-producing countries sorts itself out. This is a short-term effect based on expectations on political winners and doesn’t really have anything to do with what people mean when they talk about inflation. In the medium term QE2, last years crop shortage, and the currently deregulated commodities market (but this may change with the Dodd-Frank Finance Bill) will keep commodities prices high. Now the significant part: in the long-term increasing demand in developing countries will push commodities prices higher as consumption patterns shift for basic goods. We are seeing this with China and Russia’s growing need for influence in the oil producing regions. This may lead to a divergence between core-prices and  inflationary measures incorporating commodities (typically left out because they are viewed as more variable, which they are as this whole expectations crisis proves) ! This divergence would occur if growth in China and other developing countries was not matched with increased wages in their domestic populations. This is a very real scenario whereby ever-increasing corporate profits keep wages sufficiently low that while resource demand and production increases, consumer purchasing power remains flat. High resource prices and low wage international labor would hinder the recovery of the U.S. economy, withering investment and consumption (the U.S. consumes a lot more oil per person than any other country so higher prices would effect the U.S. the most). In this situation there is the possibility of resource-price inflation. Of course this is a worst case scenario.

In the best case, the Middle-East democracy movement ends quickly and the new powers continue to support the western status-quo. Effective financial regulation prompts banks to invest properly in business, rather than playing the commodities game. Finally, growth in China and India is coupled with wage gains that keep the U.S. competitive and allow for increased investment and consumption globally. Here resource-inflation is matched and kept in check by wage growth.

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