October 31, 2011 8:50 pm

Pendulum swings on American oil independence

oil derrick outside of Williston, N.Dakota
Looking up: an oil derrick in North Dakota. The state at the heart of a national oil boom, where once inaccessible hydrocarbons are being tapped, boasts the lowest unemployment in the US

On TheTruckersReport.com, a website that helps American drivers find out about job opportunities, the forums have been buzzing about vacancies opening up in North Dakota. As one user wrote recently, pretty much anyone who wants a job can find one there. “It’s just great that there’s actually good paying work that makes you feel like an American again,” he said.

The sparsely populated state is at the heart of the new US oil boom and there is a desperate need for drivers of equipment trucks and oil tankers. As a result, North Dakota has the lowest unemployment in the union – just 3.5 per cent, compared with national average of 9.1 per cent.
US energy charts Thumbnail

The true significance of the oil rush, however, will be felt far beyond this rural state on the Canadian border. Along with similar booms that are under way or expected across North America, from Alberta to Texas, it is a development that holds profound implications for the economy of the US and its status as superpower. In prospect is energy independence – a decades-old dream of American politicians of all stripes.

“Over the past couple of years, there has been a great U-turn in US oil supply,” says Daniel Yergin of IHS Cera, the research group. “Until recently, the question was whether oil imports would flatten out. Now we are seeing a major rebalancing of supplies.”

Many analysts expect that in the coming decade the US will leapfrog Saudi Arabia and Russia to become the world’s largest producer of liquid hydrocarbons, counting both crude oil and lighter natural gas liquids such as propane and ethane. That optimism reflects the increasing flow of “tight oil” as well as gas from shale – rock formations holding reserves unlocked through new extraction technologies.

Hydraulic fracturing (pumping a mix of water, sand and chemicals underground at high pressure to crack the rock) and long-reach horizontal drilling (sending wells up to a mile sideways and more than a mile below the surface) have transformed US gas production, opening up reserves some estimate will last 100 years. Now these techniques, used in places such as North Dakota, are having a similar impact on oil output. Already, America has cut the share of its oil consumption met by imports from more than 60 per cent in 2005 to 47 per cent last year.

There is still plenty of uncertainty about the outlook. “You can’t just draw a straight line into the future,” Mr Yergin warns.
Nevertheless, the growth in US and Canadian production from new sources, coupled with curbs on demand as a result of more efficient use of fuel, is creating a realistic possibility that North America will be able to declare oil independence.

The benefits of such self-sufficiency are sometimes overstated. The oil market would still be global and economies interconnected – so the fates of Saudi Arabia, Iraq and other oil-producing countries will remain vital issues for the US. However, a smaller oil import bill would cut the US goods trade deficitpetroleum has ac­counted for 44 per cent this year – and make it more resilient to shocks and supply disruptions in times of conflict. It could also curb the flow of revenues to un­friendly or undemocratic nations and chip away at the power of oil producers’ cartel Opec.

Edward Morse, a former US energy diplomat now global head of commodities research at Citigroup, the American bank, believes it will be possible for the US to cut imports from about 10m barrels per day to about 3m b/d by the early 2020s. All of its import demand could be met from Canada and Mexico. “The two vulnerabilities of the US as a global superpower have been its dependence on imported oil and its current account deficit,” he says. “Now it may be in the process of resolving both of those.”

For decades, talking about oil independence has been seen in the energy industry as a sign of failure to understand the scale of the challenge. Every US president since Richard Nixon has talked about curbing dependence on imports and each has failed to do much about it. But it no longer seems so far-fetched. As recently as 2007, the National Petroleum Council, an adviser to the US government with members from the industry, academia and environmental groups, concluded that it was “unrealistic in the foreseeable future” and suggested the best that could be hoped for was a slowing of the decline in US oil production.

Its most recent report, published in September, reiterated the scepticism about independence. However, it was much more optimistic about the potential for US oil output to grow. “It’s amazing how far we have come in just four short years. And we’re just seeing the beginning of it,” says Clay Bretches of Anadarko Petroleum, who worked on the NPC study.

In 1956, geologist M. King Hubbert, the originator of “peak oiltheory, predicted US production would hit a peak by the early 1970s and then go into decline. For three decades, it seemed he was right. Production peaked in 1971 and fell relentlessly for more than 30 years.

In 2009, however, US output started to grow again, led by offshore production in the Gulf of Mexico then on­shore tight oil. Techniques such as those being used in North Dakota are being tried in tight oil reserves all over North America: in the Eagle Ford shale and Permian basin in Texas and the Utica shale in Ohio and Pennsylvania. IHS Cera forecasts that US tight oil production will rise from 900,000 b/d this year to 2.9m b/d in 2020roughly half today’s total US output.

Meanwhile, in the same period, Canada could double production from the Alberta oil sands to about 3m b/d, as improved production techniques turn a marginal, high-cost resource into a more profitable commercial proposition. Canada, already a net exporter, overtook Saudi Arabia in 2004 to become the largest oil exporter to the US and its lead is set to grow.

In 2010, the US and Canada produced almost 10m b/d and consumed about 22.5m b/d. Given the right opportunities and incentives – and the access to closed areas such as America’s east and west coasts for which the oil industry is lobbying – by 2035, the two countries’ production could rise to 22m b/d, the NPC suggested. If demand could be held constant, that would cut North America’s shortfall to just 0.5m b/d.

Such a constraint on consumption certainly looks achievable. Many analysts believe the US, like other ad­vanced economies, is entering the era of “peak demand”, in which oil use has risen as high as it will go. A slowdown in car use, tighter fuel economy standards for vehicles and greater use of ethanol, hybrids and electric vehicles are all helping to hold down demand. It is quite possible that 2007, when the US used an average of 20.7m b/d, will form a historic high.

Like predictions of rising supply, forecasts of falling demand could be wrong. Professor Timothy Mitchell of Columbia University warns that if rising North American production weakens political pressure for greater fuel efficiency, oil consumption could rise again.

America’s dependence on imports will continue to be the outcome of a mix of political and geological factors,” he says. Yet even if the most optimistic hopes are not fulfilled, one can imagine a future in which the US imports oil only from Canada, Mexico and a handful of other friendly countries, such as Brazil.

The significance of the specific source of oil imports is often overstated. As Prof William Nordhaus of Yale University has explained, the global oil market can be compared with a big bathtub into which all producers pour their fuel and from which all consumers draw. The world’s tanker fleets make oil a highly mobile commodity; and changes in supply, wherever they occur, affect all consumers. The fact that the US imported almost nothing from Libya did not save it from being hit by the rise in prices when Libyan production was taken off the market this year.

So even if the US one day imports oil only from Canada, it will still suffer when there are global supply shocks and price spikes. Production from the Middle East, and traffic through the straits of Hormuz in the Gulf and Malacca between Malaysia and Singapore, the choke points for world oil transport, will still be vital US strategic interests.

That said, the more the US can meet its needs domestically, the more it will be protected against the economic impact of rising prices.
An oil shock would lead to a redistribution of income within the country but not to other countries. Similarly, it would be preferable to pay more to Canada, which has tight trading links with the US, than to some more remote economy. As Mr Yergin says: “This means a lot of dollars staying in the US and Canada that would otherwise have gone elsewhere.”
Politically, too, if any nation is to benefit from rising oil revenues, the US would prefer Canada to, say, Iran.

Higher North American production would also help offset the power of Opec. Forecasts suggest Opec’s share of world output could rise from about 40 per cent today to more than 50 per cent during the 2030s, as mature reserves in non-Opec countries are depleted. Stronger oil industries in the US and Canada could not strip the cartel of its influence but might create a deterrent to any attempt to hold prices too high.

Moreover, says Michael Levi of the Council on Foreign Relations, a New York-based think-tank, the global oil market’s smooth functioning cannot always be relied on. In extremis, amid global conflict, a self-sufficient North America could shut itself off from the world oil trade altogether.

But the most powerful arguments against increased North American production are likely to be rooted in concerns about the environment. There are widespread moves to obstruct hydraulic fracturing and the planned Keystone XL pipeline, intended to take output from Canada’s oil sands to refineries on the coast of Texas, has been the focus of weeks of protest.

Despite such objections, many Americans will find the prospect of greater energy independence seductive. At a time of economic weakness and concern that the US is falling behind China in influence, America’s rise as an energy power is a reason to think its pre-eminence can survive.

“The notion that the US was a superpower in the 20th century but won’t be in the 21st doesn’t hold up so well now,” Mr Morse says. Compare it to a country such as China, which is going to be overwhelmingly dependent on energy imports. The US is in a much stronger position.”
Copyright The Financial Times Limited 2011.

Markets Insight

November 1, 2011 3:34 pm

QE3 on its way as Fed prepares Phillips trial

When Ben Bernanke, chairman of the Federal Reserve, emerges from his meetings with the Federal Open Market Committee, he addresses the media in that most Delphic of dialects – “Fedspeak.” Like any good central banker, he is careful to preach the piety of price stability. Even if he believes that more inflation could help the US economy, he would be hard pressed to admit it.

His allies on the FOMC, however, have more leeway. Charles Evans, president of the Chicago Fed, for instance, has openly declared his desire for more inflation.

“Given how badly we are doing on our employment mandate, we need to be willing to take a risk on inflation,” he said on October 17. For Evans, this would entail keeping rates near zero until unemployment dips below 7.5 per cent or inflation rises above 3 per cent.

Although 3 per cent inflation would run well above the Fed’s implicit target of just under 2 per cent, Evans is not alone in his appetite for risk. Fed vice-chairman Janet Yellen and Boston Fed president Eric Rosengren also endorsed Evans’ proposal. Even Fed Governor Daniel Tarullo, who seldom addresses the public, recently encouraged additional monetary easing.

This rhetoric about the trade-off between inflation risk and growth reminds me of the early 1960s, a time when economists believed in the Phillips Curve: the idea that higher levels of inflation can reduce unemployment.
If the Fed is thinking about the Phillips Curve, that tells me that QE3 is on the way.

One can’t rule out QE4 or QE5, either. Though additional stimulus may arrive in a myriad of forms and labels, one thing is clear: the era of unconventional monetary policy is far from over. In fact, we may have only seen the opening act. Unlike the European Central Bank, which has a single mandateprice stability – the Federal Reserve seeks price stability and full employment. It’s not inflation the Fed wants. It wants jobs.

Here’s how the Phillips Curve comes into play. In 1958, a New Zealand–born economist named William Phillips published research on the relationship between unemployment and the rate of change of wages. By studying British economic data between 1861 and 1957, he found that a burst of inflation brought higher nominal wages.

When nominal wages rose faster than producers increased prices, consumers felt wealthier. The wealth effect spurred near-term consumption and higher nominal gross domestic product, leading to a decline in unemployment.

Intuitive and empowering, Phillips’s theory quickly spread from academia to execution. When John F. Kennedy took office in 1961, unemployment was 6.9 per cent and inflation 1.4 per cent. So Kennedy cut corporate taxes, and the Fed eased. By 1967, inflation and unemployment had converged at 3.8 per cent. It was a halcyon day for economists.

This dreamy state, however, was shortlived. The notion that inflation and unemployment were inversely correlated collapsed during the 1970s, when both went up. In studying why things went awry, economists learnt that the Phillips Curve works during periods of stable inflation expectations.

In order to get a wealth effect, incremental price increases must exceed upward adjustments to inflation expectations. Once both producers and consumers expect prices to rise, the wealth effect vanishes, along with its ability to spur nominal growth.

With inflation expectations unglued, actual inflation loses its punch, and the inverse relationship with unemployment breaks down. This is what happened during stagflation in the US during the 1970s. By the mid-1980s, the theory that inflation could permanently boost employment had been debunked.

Although it may not hold over long periods of time, the Phillips trade-off can work in the short run, especially when inflationary expectations are well anchored. In fact, with unemployment high and inflationary expectations low and declining, the current economic climate might be perfect for a Phillipian experiment. Five-year expectations for US inflation are below 1.5 per cent, down nearly a full percentage point since April.

This is why I believe some of Bernanke’s cohorts are suggesting that a bit more inflation, at 1.6 per cent in the US, would help to ease the nation’s 9.1 per cent jobless rate.

With renewed faith in the Phillips-Curve trade-off, the Fed is likely to pursue a period of higher inflation in hopes of reducing unemployment. In the short run, it probably works, but a prolonged dependence will lead us to the same end: stagflation. No matter. The implicit return of the Phillips Curve to Fed rhetoric sends a strong message to investors: if the Fed secretly wants a little more inflation, it will get it one way or another.

That’s not necessarily all bad for the US. In the near term, the moral of the story is what I’ve been preaching for some time now: the rising tide of liquidity will buoy asset prices, especially US equities.

Scott Minerd is chief investment officer at Guggenheim Partners

Copyright The Financial Times Limited 2011.

November 01, 2011
A couple of really dumb moves highlight the massive sell-off seen in equity markets Tuesday. The first came from Greece where Prime Minister Papandreou after committing to a deal with the EU had a change of heart and wants a public referendum. That’s nice but clearly blindsided markets and his EU brethren given this wasn’t part of the deal.

The concern is banks have agreed to a voluntary haircut in sovereign debt. Should the public reject it (and they’re 58% against it per recent polls) then a default would become involuntary triggering massive CDS (Credit Default Swaps) events where counterparty risk is questionable. There may be over $500 billion of this debt with most held and/or issued by the top five U.S. banks. This creates more uncertainty than the markets can handle.

Next in the Focker household is Jon Corzine, CEO of now bankrupt MF Global (MF). He was a Goldman Sachs CEO, U.S. Senator and NJ Governor who destroyed NJ financially. As CEO of MF, earning $14 million in 2010, he evidently approved large speculative positions in euro zone debt which then blew-up that company. Given his background in securities management one would be shocked to know the company is alleged to have invaded and/or stole $300 million of segregated client assets. If true, this would be criminal fraud and we’ll see those involved with some jail time.

Naturally stocks globally tanked on this news as November begins heading south like so many snow birds. A two day drop of nearly 500 Dow points is more than just mere profit-taking. The volatility remains intense with two-way action remaining much with us. Last week’s previous sector leaders like materials (XLB) and financials (XLF) reversed course sharply. Taken together, it’s no wonder Main Street investors are fleeing a corrupt and volatile investment world.

Gold fell moderately as the dollar rallied along with bonds. Commodities overall took the hit pretty hard on both the Greek situation but softer data from China overnight.

Volume was much heavier Tuesday as investors most likely took off positions from the previous week. Breadth per the WSJ was negative and looks close to a 10/90 day.

ETF Digest subscriber and friend, David Hurwitz, confirms a 10/90 day bearish day.

Wednesday brings us a Fed meeting result which isn’t expected to do much but governors are paying attention to economic data and the euro zone situation. They could either hint at QE3 or actually launch it.

What’s going on in the global financial system seems unprecedented. This is the type of action we experienced in the Great Depression but not since. Then there was a 10 year bear market relieved by WWII and pent-up demand. It’s hard to say what will happen next but curing centrally planned economies and socialist regimes hasn’t worked in the past and probably won’t work now.

Let’s see what happens.

Striking Euro Gold (and Silver)

Harold James


PRINCETON – The alternatives for Europe’s currency, the euro, seem increasingly limited to a desperate muddling through or a chaotic collapse. But there is a bolder and more productive approach that relies on past experience with multiple currencies.

The threat posed by Europe’s current policy impasse can hardly be overestimated. In the early 1930’s, monetary-policy incoherence paralyzed US policy, with the Federal Reserve Bank of New York locked in insurmountable conflict with the Chicago Fed over monetary easing (at that time through open-market securities purchases). Today’s chronic policy disputes between Germany and France are producing a level of uncertainty that is potentially even more destructive.

Every few months, European governments launch a new and ever more ingenious initiative to resolve the eurozone’s debt crisis. For a day (and sometimes only for a few hours), financial markets rally euphorically. But soon doubt sweeps back in. There is no sense of a realistic endgame. And there is no longer-term vision of how the fiscal integration needed for the effective operation of a monetary union could be achieved in a practical timeframe.

Europeans should look to the past, when previous crises produced innovative solutions. The extended crisis of the European Monetary System (EMS) between September 1992 and July 1993 looked as if it would derail European integration. What was initially seen as a problem in one country (Italy) toppled other currency regimes like dominos: Britain, Spain, and Portugal – and, by July 1993, even France was vulnerable. Then, as now, Europe’s future was at stake.

The solution adopted in frantic late-night negotiations in Brussels initially looked counterproductive. The massive widening of the EMS bands to 15% on either side of a central parity initially made a single currency appear more remote. But it also took away the one-way-bet character of speculative attacks on vulnerable currencies, and thus removed the fundamental driver of instability.

The modern equivalent of the band widening of 1993 would be to maintain the euro for all members of the eurozone, but also allow some of them (in principle, all of them) to issueif necessarynational currencies. The countries that did would probably find that their new currencies immediately traded at a heavy discount. California recently adopted a similar approach, issuing IOUs when faced with the impossibility of access to funding.

The success of stabilization efforts could then be assessed according to the price of the new currency. If the objectives were metfiscal stabilization and renewed growth – the discount would disappear. In the same way, after 1993, the French franc initially diverged from its old level, but, in a good policy setting, it then returned within the exchange-rate band.

This approach has an important advantage: it would not require the redenomination of bank assets or liabilities. As a result, it would not be subject to the multiple legal challenges that a more radical alternative would run into.

Of course, there would also be the possibility that no convergence would occur, and that the two parallel currencies would coexist for a much longer period. This is not a novel thought. One of the possibilities raised in the discussions on monetary union in the early 1990’s was that a common currency might not mean a single currency. That possibility is not just a theoretical construct in fringe debates two decades ago; it is a real historical alternative.

In fact, there is a rather surprising parallel for stable coexistence of two currencies over a long period of time. Before the victory of the gold standard in the 1870’s, Europe had operated with a bimetallic standard for centuries, using silver as well as gold. Each metal had its different coinage. This regime was so successful in part because the coins were used for different purposes. High-value gold coins were used as a reference for large-value transactions and international business. Low-value silver coins were used for small day-to-day transactions, including payment of modest wages and rents. Silver was what Shakespeare termed the “pale and common drudgetween man and man.”

A depreciation of silver relative to gold in this system would bring down real wages and improve competitiveness. Early modern Italian textile workers would find their pay in silver reduced, while their products still commanded a gold price on the international market for luxuries. This is one of the reasons why theorists such as Milton Friedman considered a bimetallic standard inherently more stable than a monometallic (gold-based) regime.

Nowadays, the equivalent of the adjustment mechanism in the early modern world of bimetallism would be a fall in, say, Greek wage costs paid in the national currency, as long as it was traded at a discount. These would be the silver currencies.

Meanwhile, the euro would be the equivalent of the gold standard. It would be kept stable by the institutions that already exist today, the European Central Bank and those national central banks that have no new alternative. In this sense, the core countries would be the equivalent of eighteenth- and early nineteenth-century Britain, which had only a gold-standard regime.

Maintaining a choice of currencies in a national as well as an international setting seems odd and counterintuitive. But it can – and hasbeen done, and it can be remarkably successful at satisfying peak demand for stability.
Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. He is the author of The Creation and Destruction of Value: The Globalization Cycle.