from Follow the Money

Oil, and a bit of geopolitics

February 25, 2005

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On Thursday, the Financial Times, the New York Times and Tom Friedman all weighed in on Asian reserve diversification.

Paul Blustein of the Washington Post has an A1 story today on another of my common themes: the US is taking on external debt not to invest in new export industries, but rather to fund the budget deficit and a housing boom.

It is clearly time to change the subject.

The Saudis indicated that they really don’t mind $50 a barrel oil. Shocking, I know.

The Saudis do want the world to eventually buy all their oil, and thus don’t want too rapid a move to alternative fuel sources. Consequently, they sometimes do start to worry if rising oil prices lead to a fall in demand for oil. This time around, though, high oil prices have not triggered much of a reduction in demand.

Asian economies (huge oil importers: most Asian economies have higher oil imports as a share of GDP than the US) have generally resisted letting gasoline prices rise in line with rising oil prices. Remember, China is still a communist country. The state oil companies seem to have been told to keep retail prices low. That is one way to contain inflation.

In India for example, our colleague Chetan Ahya reports that the government is not allowing the oil companies (mostly government-owned) to increase profit margins. This is akin to taxing oil companies’ profits to subsidize consumers. In China, where retail taxes are negligible, our colleague Denise Yam reports that the state development and reform commission publishes retail price "guidance" for industry participants. As a result Chinese retail energy price increases in 2004 (20%) lagged behind those in international markets (40%).

So long as Asian financing of the US continues, low US interest rates let US consumers borrow against their rising home values to keep on trucking. OK -- I am exaggerating the "made in Asia" story for effect, other factors are at play as well, but there is not much evidence, at least that I am aware of, indicating that US demand for oil is faltering at current prices.

What is not for the Saudis to like? They get to produce at capacity and make tons of money without seeing higher prices lead to any fall-off in demand.Three other points:

1) Oil (West Texas Intermediate) averaged a bit over $41 a barrel last year. If light sweet crude stays above $50 for the rest of the year, it will have a noticeable impact on the 2005 US trade deficit. A basic rule of thumb is that a $1 a barrel increase in the average oil price increases US oil imports by about $5 billion over the course of the year. So if oil averages $51 a barrel, the US oil import will be go up by roughly $50 billion. That is one reason why the 2005 trade deficit is likely to be substantially bigger than the 2004 deficit, unless something changes. The impact of higher oil prices on US exports is ambiguous: oil exporters have more money to spend on US goods, but oil importers like Germany and Japan have less. The two effects probably cancel each other out, leaving just the higher import bill.

2) The Financial Times has a lengthy article highlighting China and India’s growing interest in investing in oil. General Glut and the Global Trader are right: China is not compelled to invest in Treasuries if it thinks oil companies will generate higher returns. I suspect China’s growing commercial ties with Iran also supports Tom Barnett’s argument that a coalition of the US, Europe and even Russia ("the willing") won’t be able to isolate Iran all that effectively. China’s quest to secure access to oil and gas to meet its energy needs could well become a growing source of irritation to the US. The US would much rather than China buy Treasuries than buy Iranian oil and gas, but China may have different ideas.

3) The oil exporters are gonna have large current account surpluses this year, unless something changes. Where are they investing all their money? Probably some is going to Europe, helping to drive down the yields on a range of European assets (sound familiar?). Europe seems to be playing an increasing role in the intermediation of global savings -- flows from outside Europe into the Eurozone drive down yields on European fixed income assets, leading European investors to look elsewhere for higher returns. The net effect: both inflows into Europe and outflows from Europe, with outflows well in excess of Europe’s current account surplus.

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