Oil Shock: Mexico and China Not Exxon Stupid

The run-up in oil, commodity and food prices is not a bubble or conspiracy mounted by a cartel or speculators or dictators or ethanol.

Exxon and OPEC bashing in Congress, and off-base musings in the media and blogosphere, have it all wrong. Washington's politicians and policy makers are parochial and woefully ignorant of economic developments around the world. That is why their prescriptions are either paranoid or populist stupidity which do not address the issues.

Oil and all commodity prices are soaring, in part, because oil is denominated in U.S. dollars and the dollar declines, thanks to Washington's overspending on wars, trade, subsidies and government budgets.

Investors have also moved from banks or credit markets to commodities, thanks to the meltdown due to subprime scandals in the U.S. and the export of the bad loans to the rest of the world's banks.

But the biggest reason prices have been soaring is that astute investors are now understanding the future supply and demand reality.

The Demand Side

China and India are undertaking a Marshall Plan every two years, building massive infrastructure, urbanizing their populations and industrializing. The summer Beijing Olympics will open the world's eyes to China's economic ambitions and abilities.

Beijing plans, over the next 17 years, to urbanize about 300 million more Chinese. They will want roads, cars, buildings and streetlights. The equivalent of five New Yorks, and some 50,000 skyscrapers, are on the drawing boards. Already, 174 subway systems are under construction and a power plant is completed every month. There are already 200 cities in China bigger than Dallas.

In addition are the economic development plans underway in Brazil, Central Europe, the Middle East and other parts of Asia. More than half of the world's economy is now located in emerging, or poorer, countries.

U.S. Gasoline Prices Still Cheap

Prices are being driven upward because the world keeps buying this stuff even at these levels, both in rich and poor nations. In past times, when oil prices jumped this dramatically, there was a corresponding collapse in demand and accompanying price drop. Not this time because the price is not as high, in relative terms, as was US$36 a barrel oil in the early 1980s.
Even at $5 a gallon (which is what Canadians pay) or $7 a gallon (which is what the British pay) there will be plenty of Americans who will cling to their gasoline-guzzlers because they can afford to. Others, who cannot afford higher prices, will still have to use cars due to the fact that the U.S. is one giant, haphazard urban sprawl with minimal or no access to public transportation.

How the Other Half Lives is Different Too
Another reality is that even as prices go higher, cutbacks in usage and/or greater fuel efficiencies in rich countries like the U.S. will not offset the massive growth in consumption or the use of cars in the world's emerging economies.

Right now, the U.S. has 250 million vehicles and China, 37 million. This gap will close over time. So will car ownership in India and other poor nations.

Ironically, the poorer these countries are the more they will continue to increase demand for oil by subsidizing energy use to help their economies, farmers, businesses and families.
Another demand factor will be the ongoing need for energy and oil for power generation. On May 12, China announced it was increasing power consumption by 40% over the next three years, or 12% a year.

Currently, China is self sufficient in thermal coal but is maxed out in terms of domestic production at 2.5 billion tons per year. The supply-demand situation is tight: A 3% fall in Chinese coal production every year equates to 100% of either the U.S. or Australia's total exports, the second and third largest in the world. In other words, all the slack has been taken up in coal which means higher prices for coal and all energy commodities.

Supply is Tight, the Slack is Gone
OPEC is a factor in the supply situation but the cartel controls only 40% of production.
The real problem is that in the long run the taps cannot be turned up to drop prices because 80% of the ownership of all oil and other resources is held by foreign governments in Asia, the former Soviet Union, the Middle East, Africa and Latin America.

These government corporations or agencies are not efficient, nor responsive to market conditions. They are not devoted to replacing the resources they produce.

Even if they are disciplined and motivated to find more oil, they cannot because they are used by governments as cash cows to buy votes or palaces or armies or terrorist attacks. It costs money to gear up to produce more oil even if you already have it.

These government-controlled companies, unlike their private sector counterparts, fail to reinvest, explore, replace equipment or drill for more resources.

Besides, as prices rise there is less incentive for them to produce more. In fact, they can produce less and make the same amount.

One of the worst examples of public ownership of oil resources is Russia's Gazprom or Mexico's Pemex. This company, owned by the federal government of Mexico, has not invested in growth with the result that Mexico's oil production has begun to dramatically decline despite the existence of huge potential reserves in the country. Pemex ships most of its cash flow to Mexico City which represents 40% of the federal government budget.

By contrast, the real finders are private-sector oil or mining companies which must find new reserves to replenish their inventories or face falling stock prices and investor unrest.

Rich Countries' Options
Congressional threats to sue OPEC will only make some American lawyers rich, not add supplies in order to push down prices. Removing gasoline taxes, as Hillary and McCain proposed, is simply another foolish "subsidy" which will keep up demand by making gasoline cheaper to buy. Likewise, levying huge windfall-profits taxes on Exxon or other oil companies will merely aggravate the supply situation by reducing the cash they have with which to find and produce more oil.
The only sensible policies for the United States, Canada and other rich countries to adopt is for governments to impose dramatic fuel efficiencies on carmakers; to mandate hybrid vehicles; develop alternative energy sources such as ethanol to lower import costs and arrest urban sprawl as a means of enhancing urban density and the use of public transportation.