Monday, October 15, 2012

Manifa: Saudi Arabia’s last giant, a confirmation of commodity constraints on global growth.

            The Manifa field in Saudi Arabia is estimated to hold about 12 billion barrels in proven reserves, and the project that is currently in progress will add 900,000 barrels per day of extra production to the claimed capacity of 12.5 mb/d that the Saudi’s claim to have but never actually produced.  The project will likely be completed by around 2015, although some suggestions were made that it will be done a lot sooner.  This is Saudi Arabia’s last giant field waiting to be fully developed.  Production expansion may proceed at other giant fields in the future, but increases will be modest at best, and most likely, most projects will actually be meant to keep production from declining.  The Saudi kingdom still has many smaller fields, which can be brought online, but most of them will have a very short lifespan, and none of them will produce significant enough volumes to greatly affect Saudi Arabia’s overall production volume.  At best, they will help mask the decline in many of the Kingdom’s aging giant fields.  It is safe to say therefore that with the completion of Manifa, we will most likely reach the maximum point of Saudi production capacity this decade, and there will only be one direction from then on, and that is down.

Why this should not worry us for the short run:

            The most common response to this sort of news is to try to deny the facts.  Saudi Aramco, will make empty statements about how they could keep increasing their production rate for many decades to come.  Western analysts will back those claims, or point to the US as the next Saudi Arabia, given that fracking has greatly increased oil production rates at the Bakken and Eagle Ford shale oil projects.  Then there are also those who say that it does not matter, because we have plenty of other resources, such as natural gas, coal, and of course renewables such as bio-fuels, wind, solar and so on.  Technology in conjunction with guidance from the market is also making us ever more efficient.  Thanks to these factors, taken individually, or together we will prevent our society from suffering through the much feared super spike in global oil prices, which many who believe in the peak oil event claim that is upon us

            Those are all great stories, but the real story, which should give us reason not to worry for the immediate future, is the slowdown in the global economy since the last oil price spike in 2008.  China, which was the engine of demand last decade, has slowed down significantly in the past year, and this may have become the new normal.  Dow Chemical’s CEO, recently stated in an interview on CNN that he believes that China’s economy is only growing at the low rate of 2-3%, as opposed to last decade’s trend of 10%, despite China’s current claim that they are growing at 6-7% annually.  The rest of the emerging world is also in slowdown mode, and will probably be so for a while.  Europe is a big mess, the US will likely have to deal with that 8% of GDP deficit eventually, and they cannot hope to grow out of it.  Spending cuts, and increases in tax collection will have to be implemented, and that will lead to a further slowdown in growth in the world’s largest economy.  The only place where we should expect continued sustained increases in demand is the same place where the oil exports come from, such as the Middle East, South America, a few places in Africa and Canada.

            Considering all this, it is safe to say that we no longer have to fear a price spike, unless a sequence of unforeseen events will cause a large chunk of total global production capacity to go offline for a considerable amount of time.  The only thing I can think of at this moment, which would fit the description, would be a regional war in the Middle East, involving most oil producers, including Saudi Arabia and Iran.  Aside from that, the price of oil should remain in the $100 to $140 range for the Brent benchmark for the rest of this decade, and probably next.  There is in fact more of a chance that the lower end of the trading range will be breached than the higher end.  Even if total global liquid fuel production will stagnate, in the next few years, it is still not enough to warrant a breach of the upper end of the price range for a sustained period.  The weak economy will react to the price by undergoing demand destruction.  So all the advice out there for people to expect great increases in the price of oil and adapt accordingly are in fact misleading those who believe this to be the case.

Implications for the long term:

            My prediction that there is very little chance that there will be another super-spike in oil prices may sound like good news, except as I already pointed out, the reason for us not to expect a super price spike very soon is the struggling global economy.  For the longer term, what this means is that Saudi oil exports will decline by possibly significant volumes, depending on how well they will perform in their effort to constrain domestic demand, which has been running at over 5% growth per year on average, for the past five years now.  If they can dampen that growth rate to maybe 3% per year, perhaps we will lose only about a million barrels per day of global net exports per decade, assuming that Saudi Arabia will continue to produce at current levels for many decades to come.  There will likely be an increase of perhaps two or three million barrels per day from Iraq in the next few decades, which should make up for that (if all will go well).

            On the demand for oil imports front, I think it is important to recognize that the EU, the US, and Japan, will likely continue to decrease their reliance on oil imports, due to varying factors, the most important of which is the stagnated economy in these countries and regions.  Increased production from US unconventional sources will also play a role, although we have to keep in mind the continuing decline in the North Sea region, as well as the coming decline in Gulf of Mexico production, which will decline at a similar pace that US unconventional oil will come online.  I believe it is reasonable to expect that demand for oil imports from these countries will decline by 2030, by about 3 million barrels per day.  In this assessment, I expect the economy of these countries to grow collectively at an average of 1% per year, while efficiency gains will amount to 1.5% per year, giving us an average net decline of .5% per year.  Currently, these countries and regions consume collectively about 35 million barrels per day, out of a total of 88 million barrels per day consumed worldwide according to EIA data.

            Increased demand for imports will mainly come from Asia, but it is important to recognize the slowing trend happening there.  Economic growth in Asia, excluding Japan should continue at a pace of about 4% per year, and if we are to adjust for 1.5% in efficiency gains there as well, we get average growth of 2.5% per year for oil imports until 2030.  Current consumption in the region is about 24 mb/d, excluding Japan.  So, by 2030, they should in the absence of a total global economic meltdown consume about 37 mb/d.  That increase of 13 mb/d, will in part be offset by declines in demand for imports from the US, EU and Japan of 3 mb/d.  It is possible that South America, Africa, Canada, as well as possibly Central Asia, could collectively bridge the gap of the 10 mb/d extra imports that Asia will have to source.  After 2030 however, I doubt that things will be so simple, because we are running out of places where there is still potential for production growth.

            So as important as the story of Saudi oil production is, it is important to remember to draw the right conclusions.  Manifa is a piece of the puzzle which gives us reinforcement for the view I expressed in my book as well as in my blog. For reasons that no longer have anything to do with the size of government, or tax cuts, we are faced with a growth rate ceiling that is gradually moving lower (Read my March article on maximum potential GDP growth to 2030 Here for further clarification on the situation.  The most recent IMF growth outlook, seems to confirm my views).  With the US, EU, and Japan collectively growing at the painfully slow pace of 1% per year on average, while Asia will have to slow to 4%, from about 6% in previous years, we are looking at a painful future. Politicians in the west try to convince us that government spending and taxation are important, mainly because these are the only factors they have the ability to talk about and control, given their ideological constraints.  Unfortunately, it is becoming more and more evident that as far as our long-term economic trajectory, these issues are becoming more and more irrelevant.  The fact that Manifa is Saudi Arabia’s last giant field in their portfolio, yet to be fully developed is a far more important factor for the future than Romney’s tax cuts, Obama’s “Obamacare” and a host of other hotly debated issues.  This is something to consider, especially for the American electorate, which has been bombarded with a media blitz on these issues for months now, despite the fact that there are more important but unfortunately complex issues we need to deal with.

Monday, October 1, 2012

Tax cuts: A viable alternative to addressing the real root of the global crisis?

            The world and many countries and regions within, have been in economic crisis mode for half a decade now.  I often pointed out on the blog and in my book that something fundamental changed in the middle of the last decade.  The economic environment is no longer what it was; therefore the set of ideas contained within the left/right ideological camps no longer hold relevance when it comes to addressing our problems.  We need new ideas urgently, but as long as the old ideological divide continues to solidify, no relevant new idea can ever come to the forefront, because nothing of actual practical applicability can ever pass the ideological purity test on either side, therefore we remain stuck recycling old ideas, many of which did not necessarily work all that well in the past in the first place, yet we continue to receive the same remedy, even though the sickness is something completely new and as I shall ilustrate through my example, completely resistant to the current arsenal of remedies offered by our politicians.

Tax cuts as a way to restart the economy:

            With the US elections approaching, we have one of the most important, globally significant economic policy decisions being put on the ballot for the US electorate to decide.  They have the choice of the current administration versus choosing a new one, which has as its main economic policy approaches a belief that cutting taxes is the way to get the economy back on track.  I recently had a conversation with someone about this, and it really helped me understand why it is that ideologically right leaning people may believe this to be an unquestionable fact.  He pointed out to me that the Reagan tax cuts helped the US economy recover from a dismal economic situation left by the Carter administration.

Some background facts on the real effect of tax cuts:

            It is true indeed that there was a recovery during the Reagan era, and we might be tempted to jump to the conclusion that tax cuts are the answer to why the recovery happened.  I disagree with that notion, because there is one other important aspect we need to remember.  Taxes were cut, but the deficit also ballooned as a result.  There were no significant spending cuts to offset the decrease in revenues collected.  In effect the US economy received an infusion of money, acquired through debt issuance.  In fact, inflation adjusted deficits were more than doubled in the 1980’s compared to the 1970’s.

$17    Billion
$130  Billion
$129  Billion
$77    Billion
$28    Billion
$226  Billion
$297  Billion
$203  Billion
$208  Billion
$128  Billion
$206  Billion
$200  Billion
$304  Billion
$479  Billion
$409  Billion
$453  Billion
$463  Billion
$302  Billion
$301  Billion
$282  Billion

(See endnote for reference)[i]

            As we can see from the chart, the Reagan administration can be summed up as one where deficits doubled from the previous administration.  Such an infusion of money into the economy could only have one effect and one effect only, and that is to stimulate spending.  We should also make note of other factors that had little to do with Reagan and his presidency, but did contribute to economic stability.  Inflation moderated considerably, giving a boost to the economy as well.  In 1980, inflation was at 12.5%, and it fell to 3.8% by 1982.

The effect of such a tax cut in today’s context:

            The deficit for 2012 is estimated to come in at over one trillion dollars.  There is therefore no room for more deficit spending to stimulate the economy.  The tax cut would have to be accompanied by budget spending cuts, otherwise the US might be greeted with an unpleasant surprise in the form of an earlier than expected visit from the bond vigilantes, who might come to lynch US government debt.

            Some may claim that this would still have a stimulative effect even if government spending were to be cut, because the multiplier in the economy of private investment is greater than that of government spending.  I will not get into the debate of what is the multiplier effect of each form of spending.  I will reserve a comment I want to make on the effect that cutting the social safety net can have on consumer spending a bit later.  I will take the assumption from the right that private investment will yield a greater multiplier effect than government spending for granted, and give it a multiplier effect of x4, versus x2 for government spending.  In other words, a 1% of GDP increase in private sector investment should yield a 4% growth of GDP[ii].

Effect of a $100 billion per year tax cut accompanied by spending cuts:

            The simple math given the higher multiplier effect of private investment would lead us to the conclusion that the US economy would get a stimulative boost of $200 billion, given that cutting government spending by $100 billion would cut $200 billion out of the GDP, while boosting private investor spending by the same $100 billion per year would increase GDP by $400 billion.  Taking a closer look however we should realize that we can easily yield a very different conclusion if we look at the details.

            First off, the US Republican tax cuts would indeed mainly benefit the top 10% of earners, since they pay more income taxes.  Many of them are business owners, big and small and major shareholders, but not all of them.  A great number of them are actually high earning professionals such as doctors, lawyers, academics, engineers, financial analysts and many more who manage to earn a decent living doing what they do.  It is hard to argue that these people would in fact increase consumption by more than the resulting drop in consumer demand as a result of cuts made to benefits and services.  Poor people and lower middle class earners are more likely to spend on much needed goods and services than people who already have many of their basic needs met, and already have a healthy discretionary spending income.

            A doctor, who already makes $500,000 net per year, might be tempted to buy a second house in Tuscany, or a cabin in the pristine Canadian wilderness if given an extra $20,000 per year in the form of a tax break.  This might actually lead to the doctor spending far less in the US, given that he/she would be more likely to invest more money and time in the new property.  Similarly, other professionals earning in the six figure range might be tempted to take more leisure time in foreign lands, thus actually decreasing their consumption level in the US as a direct result of the extra money derived from the tax cut.  It is hard to gauge what percentage of the $100 billion tax cuts would go to this category of individuals, but my guess is that it would be a healthy portion, of perhaps as much as half.

            That would leave $50 billion in the hands of actual investors, so one might still be able to argue that while the tax cut would not have the $200 billion net GDP boosting effect originally assumed, it might still be perhaps $100 billion, therefore trickle down would work.

            I take issue however with the assumption that given an extra $50 billion per year to keep, investors would actually invest all of it and invest it in the US.  That might have been a reasonable expectation in Reagan’s time, but now with globalization in full swing, I think it would be outright foolish to expect this.  Some of that money would go to debt reduction and perhaps a further increase in personal income for the investors.  It is impossible to predict how much, but given that it is a well known fact that big companies are already sitting on piles of cash they refuse to deploy for the past few years, it is not unreasonable to believe that perhaps the lion’s share of that extra income would go on top of that pile of idle cash.  As for the money that will be invested, given the investment pattern of big companies in the last two decades, it is reasonable to assume that most of it would end up somewhere else, since building factories and other production facilities in cheaper environments is a sure way to boost profit.

            I also wanted to bring us back to the issue of the consumer demand effect that cutting benefits and services, the government currently provides, would have.  People are already feeling uncomfortable with the level of uncertainty in terms of job security, unforeseen investment losses and other financial issues.  Cuts to unemployment benefits or even to the food stamp program, could easily have a disproportionate counter effect caused by tens of millions of wage earners deciding to cut consumption drastically in order to be able to build a small personal safety net of their own.  The effect could add up to hundreds of billions per year, and a resulting recession could induce a spiral effect, where the resulting recession would cause people to cut more spending, thus increasing unemployment and uncertainty and more contraction.

            Going back the expected resulting investments stemming from the tax cut, we have to remember that the primary factor involved in investments is the expectation of consumer demand.  Current industrial capacity in the US is used at 79.3% according to the latest Federal Reserve figures.  It is 1% bellow long term average starting from 1972, so it is not disastrous, but it is a sign that consumer demand is still quite weak, and building more capacity is not warranted at the moment.  Some investment may be made in modernization, but that in the absence of growth in consumer demand might actually lead to job loss, because modernization usually leads to an increase in productivity levels, and a corresponding decline in labor demand.  Taking all these factors into consideration, it is fair to say that at the very least we cannot be certain what effect tax cuts would have on the medium term economy.  It is therefore disingenuous of right leaning people to claim that we should automatically assume that tax cuts would bring back the good times, which seem like an increasingly distant memory for many of the people affected since the 2008 economic downturn.


            When looking at ideology based ideas, I try to be as neutral as possible.  Anyone who ever read my work should realize by now that I do not adhere to political preferences.  I have been critical and supportive of both the left and the right whenever I felt that it was warranted.  For instance, I often voiced my opposition to the idea advanced currently by the Obama administration that investing in the green economy will give the US an edge, given that it is the future of technology and economics.  I believe that China’s policy of building massive capacities of coal powered plants, while only investing comparatively token resources in green tech will make them more competitive economically than any country focusing on trying to be voluntarily good global citizens.  A niche market for heavily subsidized electric cars is not the way of the future in my view (which I expressed in a previous article: Link).  A standardized global trade tariff, designed to promote sustainability on the other hand could on its own push for these green technologies to be applied worldwide, not just in niche markets, as I pointed out in my book.

            I mentioned that something fundamental changed in the middle of the last decade, which forever changed prospects for our economic future.  Few people are aware of this but in 2005-06 conventional crude oil reached a plateau in production, and it has not increased significantly since, despite sustained higher prices.  The only increase in liquid fuels came courtesy of unconventional sources, which only make up about 20% of total supply.  Some argue that the oil price spike of 2008 is what caused the great recession.  Many people argue against this, but let us be honest.  If there would not have been a deep recession in 2008, we currently would be in a situation where global oil consumption would have been outpacing supply for half a decade now, and the gap would most likely be widening.  Prices would therefore be unbearable right now.

            So let us think back to the proposal of tax cuts to promote growth.  It is a little bit like when Adolf Hitler ordered the offensive on the western front in the Ardene forest in Belgium, in 1944 (Battle of the Bulge). Despite not having the necessary fuel to keep his army moving forward for a sustained period, he went ahead with it anyway.  In the end, the losses did not justify the gains, and the Whermarcht was pushed back.  Tax cuts, even if we were to assume that my analysis is wrong and it would indeed lead to economic growth in the US and thus worldwide, given the size of the US economy would not keep the good times rolling for long. How long before we would reach another point where demand will outstrip oil supplies and we would hit the wall as hard, or even harder than we did in 2008?  Total liquid fuel supplies worldwide have been increasing at a pace of .5 mb/d per year since 2005, when conventional oil plateaued.  To get back to the economic expansion we witnessed until then, we would need for that average increase to at least double or about 1 mb/d per year.  So the best republicans can hope to see courtesy of their tax cuts is a period of growth of a few years, and hopefully they will be out of office, once it all hits the wall again as it did in 2008.  Then, they can point the finger at the other guys and point out that when they were in office the economy was growing, so naturally the new guys must have messed up, so people should elect them again.  Meanwhile neither side will effectively address the underlying issue of resource constraints on growth (I addressed this issue in more detail in this article  Link), and thus we will dig ourselves deeper and deeper into a hole and squander our remaining vibrancy on a futile attempt at getting back to the pre 2005 economy.


[ii] The multiplier numbers I used are purely fictional, and I should also point out that while economists have been attempting to measure multiplier effects of various types of infusions of money into the economy, there is no standard multiplier number that can be applied, because there is never agreement on what the number is.  As variables change, so does the multiplier.  The main variable is the Marginal Propensity to Consume (MPC).
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