The BP Oil Spill Means Heightened Stagflation Risk

The BP Oil Spill Means Heightened Stagflation Risk

Justice Litle, Editorial Director, Taipan Publishing Group Wednesday, June 02, 2010

The BP oil spill is now recognized as the worst environmental disaster in U.S. history. It is also shaping up to be a harbinger of stagflation.

The BP oil spill is not just an environmental disaster. It is also an economic disaster. Thanks to fallout from what's happening now in the Gulf of Mexico, the long-run odds of stagflation have greatly increased.

Stagflation is more or less defined as the unholy combination of a high inflation rate and a high unemployment rate. Generally speaking, you are not supposed to get these things together. It's an awful pairing because stagflation implies higher prices for everything important – gasoline, food, basic staples, and so on – even as much of the country finds itself out of work.

The oil price is a major potential driver of stagflation because, well, the price of crude oil affects virtually everything. From basic transportation, to fertilizer products for the food we eat, to the millions of varieties of plastics we all interact with everyday, crude oil shows up most everywhere..

Fool Me Twice BP, Shame On Me – Fool Me Five Times...?

As a side note, we observe with sadness that, much as we thought might happen, the 'Top Kill' effort to plug the crude oil leak has failed. Now we hear British Petroleum (BP) promising to try another effort, and then yet another. Something involving golf balls... something else involving relief wells and hacksaw-wielding robots... it all sounds like a bunch of public-relations speak. (Plain English translation: "clueless and flailing.")

Energy expert Matt Simmons believes BP has no handle on the situation... that there is actually a far worse oil leak happening some distance away... that a staggering 120,000 barrels of crude oil per day are spewing into the Gulf of Mexico... and that the only sensible course of action at this point is to send BP away, call in the military, and arrange for small-bore nuclear weapons to address the problem, soviet Russia style.

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What your humble editor would like to know is, why does BP have any credibility left at all this point? Why should we believe them when they promise that their – what is it now, third, fourth, fifth – solution is going to work? Why shouldn't we believe an observer like Simmons, who takes a much harsher view of the evidence?

And by the way, at what point do we recognize that the much-vaunted problem solving capabilities of 'big government' are a big fat joke? President Obama seems to be handling the crude oil spill in much the same way he handled the global financial crisis – by letting his corrupt minions run things into the ground as the country gets screwed.

(By the way, my fellow Taipan Daily editor Adam Lass has his own opinion about oil. Sign up to read his investment commentary.)

But getting back to crude oil prices and stagflation...

Of Crude Oil and Politics

The oil chart above tells a tale of sideways movement. Crude oil prices have been more or less caught in a range for some time, due to a few key factors:

• A building supply glut in the open market has kept the oil bulls reined in.
• Fears of global economic slowdown have blunted bullish appetites.
• A strengthening $USD has put downward pressure on commodity prices in general.

That is all in the short-to-medium term though. In the longer term, creeping demand factors will still weigh heavily. And the U.S. dollar will weaken again, buoying commodity prices, as American printing presses kick into hyperdrive.

And thanks to the Gulf of Mexico disaster, a significant portion of crude oil flow could be lost as that latent demand kicks in.

Bernstein Research, a well known Wall Street house, sent a note to clients last week arguing that a one year delay in deepwater drilling projects could reduce global oil supply by half a million barrels per day in the coming years (between 2013 and 2017).

Last week, the White House furthermore ordered a halt to offshore drilling for 33 deepwater oil rigs in the Gulf of Mexico. A "moratorium" was also extended on planned new wells. Drilling permits would be frozen for another six months, the President confirmed, as the government investigated the Deepwater Horizon disaster.

Half a Dozen Reasons for Higher Crude Oil Prices

The uglier the BP oil spill gets – in both ecological and economic terms – the more heat that the politicians feel. That heat will be redirected at the major oil companies. This increases the odds that crude oil prices will march higher again – a recipe for stagflation – even as the U.S. wrestles with future episodes of economic downturn and extended unemployment. Here are a few reasons why:

• The slow, steady grind of demand outstripping supply. The developing world is still growing, and will continue to do so through thick and thin. In terms of day to day matching of global oil supply with global oil demand, there is not much slack in the system. The loss of flow from drilling projects will come just as the supply / demand equation tightens up again.

• The profit reducing impact of rising insurance costs. Insurance rates for offshore wells have skyrocketed as of late, with premiums rising an estimated 15-50%, as insurers get a hard look at the sort of serious catastrophe risk the deepwater industry entails. These higher insurance rates mean future oil projects will become more expensive, and less crude oil will be drilled overall.

• New crude oil projects being shut down or suspended. In the wake of the BP oil spill, the newly heightened risk profile for offshore drillers, "the" hard hit to oil company valuations, many marginal new oil projects will be put into suspended animation or scrapped entirely. These scrapped projects will take a sort of invisible toll on the market, as we fail to bring crude oil supplies to market that would otherwise have come online.

• Swing players and NOCs will get more clout. As America by and large withdraws from aggressive offshore production, the NOCs, or National Oil Companies, will see their role as "swing producers" increased, putting more weight into the hands of countries like Nigeria, Venezuela, Mexico and Iran when determining the oil price. Not a pleasant thought (and a recipe for being squeezed).

• The "geopolitical premium" will go up along with crude oil's volatility. Constrained or eliminated crude oil supply from friendly parts of the world will mean more sensitive exposure to chaos and conflict in less friendly parts of the world. This means we go back to watching regional flare-ups in the Middle East (among other places) with a great degree of fear and concern.

• No matter the public and political will, it will take a long time to switch. As mentioned before in these pages, a potential long run benefit of heightened oil strain is greater urgency in the drive to go "alternative", i.e. to wean the western world off fossil fuels. Yet however urgent this desire in theory, it will take an excruciatingly long time in practice to wean ourselves off of the gooey black stuff. The stunningly complex array of energy delivery infrastructures, built heart and soul around crude oil, will cost hundreds of billions of dollars (if not trillions) to upgrade and replace.

Out of Ammo

To all the above concerns, we can add a final one perhaps best summed up as "no more bullets in the gun." Because the authorities have already responded to the 2007 – 2009 financial crisis with a wave of fiscal stimulus unprecedented in all of financial history, there is little ammo left for when the next crisis comes along.

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This means that, in the inevitable return of a fear-based environment where economic health is slipping, governments will have close to zero credibility left, and no true policy tools other than monetizing debt and printing like mad with which to respond to crisis.

Against such a backdrop of diving currency valuations in the western world, we have all the more reason to see the crude oil price rocket higher – with unemployment pushing higher too.

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