The dynamics of the world energy market have changed dramatically since the Organization of Petroleum Exporting Countries first restricted the supply of crude oil. Today, there are many more producers, many more consumers and many more alternatives than anyone could have imagined 40 years ago.
One thing has not changed, however: the market focus on the price of crude oil. With geopolitical challenges facing so many oil-producing nations, the free flow of petroleum is by no means assured. Yet longer-term trends may have an even more substantial impact on this very special market, and understanding them is critical to comprehending the potential evolution of the world economy.
Brent crude oil trades around $105 per barrel as of this writing, and it has held between $105 and $115 in recent months. Effectively, geopolitical tensions in the Middle East and Ukraine/Russia have barely stirred oil prices, which averaged approximately $110 per barrel over the past three years. It appears markets do not anticipate severe supply disruptions from these events.
Since 2000, petroleum consumption in the United States and the European Union (EU-27) shows a small reduction, while China, India and Brazil use more. There is a worldwide effort to conserve energy usage, but emerging markets are nearly certain to register rapid strides in consumption of petroleum despite the drive to conserve. This is particularly true for crude oil, which is used primarily as the dominant transportation fuel in the form of gasoline, diesel, and jet fuel.
Demand for petroleum-based energy is closely tied to the pace of economic activity. It is straightforward to build future demand scenarios, bearing in mind that fossil fuels make up roughly two-thirds of the source of energy consumption. The supply of oil is a more complex matter, as it involves many factors: geologic formation; innovations in drilling technology; access to attractive acreage; geopolitical challenges; and the regulatory environment.
Technological developments and high oil prices made it commercially viable for the shale oil boom in the United States. Production reversed nearly 40 years of declines in oil output, and the United States, along with Saudi Arabia and Russia, is among the top three producers of crude oil.
However, the Energy Information Administration predicts U.S. crude oil production will peak around 2020 and then reverse trend, as the current explosive growth is based on drilling from unconventional sources that do not support sustained long-term growth. Just as the surge in U.S. oil production changed the landscape, future supply from Brazil’s deep-water drilling can further modify market conditions in the years ahead.
Geopolitical tensions influence oil supply in the very near term, while the political future of some of these countries will determine the course of oil supply in the years ahead. Of the visible threats, if the national entity of present-day Iraq collapses, it would place large quantities of oil supply at risk.
The Ukraine/Russia situation will not present a serious threat until end-2014, as Europe has sufficient reserves. In the long term, Europe will explore substitutes, while Russia will seek new customers in the East.
It’s less visible, but the possibility of future disruptions in Saudi Arabia is a legitimate concern. Threats from Iraq, Syria, Iran and Egypt are unclear; a contentious leadership succession is likely; and demands from a younger and growing population are also a challenge. A trouble-free resolution of these issues is unlikely.
For now, these simmering geopolitical problems have failed to affect oil prices significantly. The futures markets do not indicate a threatening trend in oil prices. Nonetheless, crude oil is trading at an elevated level for an extended period not seen before in history.
Industry experts point out that over the past 10 years, total exploration and production spending has grown 400%, while global production is up only 15%. The end result is that global oil production is flat for the last 10 years, which explains the elevated oil price situation.
At the same time, spare capacity in the world in trending down, while consumption continues to advance. Under these circumstances, the price of crude oil is unlikely to the return to the under-$50-per-barrel price range in the next few years.
Central banks, particularly those in emerging markets such as India and Brazil, are in a tight spot as rising oil prices stoke inflation and render focusing on economic growth a difficult task. Energy intensity of per-dollar gross domestic product (GDP) in emerging economies will be a negative for oil prices.
The overall reach of oil prices on economic activity is well known. Experiences of the 1970s point out that oil price shocks have a significant impact on output and employment. Although the link between oil prices and economic performance has moderated overtime, it is interesting to note that oil is sometimes referred to as “black gold.” That association with the most-precious of metals says much about petroleum’s hold on the public consciousness. Today’s global uncertainties and tomorrow’s global demands will both shape – and be shaped by – how the market for this unique commodity evolves.
U.S. Labor Market: Not Too Hot, But Not Too Cold
In light of the Federal Reserve’s July 30 policy statement, the employment report is under intense scrutiny to spot changes in Chair Janet Yellen’s dashboard. The official unemployment rate moved up one-tenth to 6.2% in July. Employment advanced 131,000, but a 0.1 percentage-point increase in the labor force participation rate to 62.9% resulted in a higher unemployment rate. The gain in the participation rate is in the right direction, but a larger increase in employment is the preferred combination.
The broad measure of unemployment (U6) moved up one notch to 12.2%, and long-term unemployment edged up to 32.9% in July from 32.8% in the prior month. Part-time employment as a percent of total employment slipped slightly. The bottom line is that labor market signals from the household survey remain mixed.
Payroll employment increased 209,000, putting the three-month average at 245,000. These numbers are solid hiring gains, but they are less robust compared with the June employment data. Revisions to the prior two months added only 15,000 new jobs.
In the goods sector, construction (up 22,000) and manufacturing (up 28,000) payroll employment rose. Auto-sector hiring stands out in factory employment, but it tends to be volatile in July compared with other months because of summer plant shutdowns.
Service-sector employment advanced 151,000 in July, but it represents a slower pace compared with stronger job increases seen in each of the prior three months. Retail employment (up 26,700 versus the three-month average gain of 32,100 in June), professional and business services (up 47,000 versus the three-month average gain of 67,000 in June), and health care (up 7,000 versus the three-month average of gain of 24,600 in June) posted relatively larger gains among the major categories of service-sector employment during July.
Hourly earnings rose only 2.0% from a year ago, matching the gains seen for several months in a row. The noticeably modest pace of wage growth is part of Yellen’s dashboard, and it continues to be cited in policy matters focused on slack in the labor even as hiring improves.
The details of the July employment report – widespread payroll gains; noticeably modest growth in average hourly earnings; and slightly higher readings for the unemployment rate and long-term unemployment – prompt us to leave unchanged our current forecast for the first rate hike at close to the tail end of 2015. The July employment numbers also reduce expectations of an early rate hike and offer the doves more ammunition to hold their line.
U.K.: Growth Is Impressive, but Wages Remain Problematic
The U.K. economy advanced 3.1% on an annualized basis, putting the level of GDP higher than the pre-crisis peak in 2008. Following the global financial crisis, the United Kingdom has taken the longest among the G7, excluding Italy, to reach this milestone.
Although economic activity advanced, per-capita GDP remains more than 5.0% below the pre-crisis peak. Details of the GDP components will be published in two weeks. So far in the recovery, consumer spending is the driver of economic growth in the United Kingdom. Given the soft trend of wages, it has come at the expense of a lower savings rate.
Investment spending, the forerunner of productivity gains, was about 20% lower in the first quarter than the pre-crisis peak. Exports of goods and services are still short of the high seen in 2007. Contrary to perceptions, government spending shows year-to-year gains in eight of the last nine quarters. Fiscal austerity was largely in place during 2009 – 2011.
The headline GDP numbers and the decline in the unemployment rate to 6.5% from a high of 7.9% in 2013 have raised expectations of policy tightening by year-end. But there are pockets of weakness that markets have to watch.
Real wages are hovering around levels seen 10 years ago, while productivity gains are significantly weak. The minutes of the July Monetary Policy Committee meeting indicate that the rate-setting committee finds the weakness in wages worrisome in the face of strong gains in employment.
The Bank of England could be the first major central bank to apply the monetary policy brakes, but rhetoric from the central bank also suggests it could be gradual and measured.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.