Asia/Pacific: Bursting of Oil Bubble Revives Growth Expectations
Andy Xie (Hong Kong)
Summary and Investment Conclusion
The growth scare of October may be behind us. The decline in oil prices is reviving growth expectations. I believe that the oil price could drop below US$40/bbl in the coming months. This would be good news, especially for Asia.
The current round of growth optimism may last six months. Two factors could cause growth expectations to turn down by mid-2006: (1) the tightening by major central banks could start to bite by that time; and (2) the property bubble has already begun to deflate in China and the US, which could become a major headwind for growth by the middle of next year.
The Oil Bubble May Be Deflating
The price of Brent crude dropped by 9% last week and is off by 18% from the peak in early September. Oil may be the first bubble to burst in the current cycle. If so, the price could drop below US$40/bbl in the coming months.
Oil is a bubble, I believe. The supply-demand balance is not as tight in 2005 as it was in 2004. Despite the recent correction, oil prices are still 50% above the averages in 2004. It is demand from financial buyers that has kept oil prices so high, in my opinion.
According to the IEA, global oil demand rose by 2.9 million bbl/day or 3.7% in 2004. Growth in 2004 was twice as high as the historical average mainly because of a 15% increase in Chinese demand. The market thought that the trend in Chinese demand growth had permanently changed and sharply pushed up oil prices this year.
I thought that the growth in Chinese demand at twice as fast as previously last year was due to the economy overheating and bottlenecks in electricity generation, which led to the widespread use of diesel generators. As capacity for the generation of electricity has increased at a faster rate than demand this year, the use of oil products for electricity production has declined sharply. This is why China's demand for crude and oil products has remained flat despite rapid economic growth.
Despite evidence of plentiful oil supply, the market has kept pushing oil prices higher and higher on any excuse. It looked to me like financial mania. Low interest rates and anemic returns in stock market were the catalysts in triggering speculation in oil. The momentum sucked in more and more speculators. The bubble is finally crumbling under its own weight as there are not enough new speculators to sustain the upward momentum.
Oil supply could be even more abundant in 2006. The IEA forecasts production capacity rising by 2.5 million bbl/day next year. I suspect that demand will grow by less than 1.5 million bbl/day. Rising interest rates and a supply glut in 2006 create the environment for an oil price collapse, in my view. The oil prices could drop below US$40/bbl in the coming months, I estimate.
AsiaBenefits Most from Declining Oil Prices
Asia excluding Japan accounts for 10% of global GDP but 20% of oil demand. When oil prices decline, as they are doing now, the region should benefit substantially. If Brent crude were to average US$40/bbl next year versus US$54/bbl this year, the region's oil import bill could be down by US$51 billion or 1.2% of GDP.
The overall benefit from the declining oil price in the above scenario is similar to a 5% increase in the region's exports. Since the region's exports are growing three times as fast as that now, the fluctuation in oil prices is certainly less important than global trade momentum. However, this benefit could offset som e US consumption weakness in the first half of 2006.
The distribution of the benefits from lower oil prices could be counterintuitive. Because China has benefited so much from the increased purchasing power of oil exporters (see Diverse Effects of Expensive Oil, November 7, 2005), the benefit of low oil prices for China could be offset by lower export income to oil exporting economies.
One major benefit from a fall in oil prices is less inflationary pressure. Indonesia and Thailand have been hit particularly hard in that regard. Both have had to increase interest rates rapidly to contain inflationary pressure. A drop in oil prices would give them much needed flexibility in monetary policy.
Growth Momentum Could Slacken by Mid-2006
Declining oil prices could be the last significant stimulus for growth in this economic cycle. However, growth headwinds are intensifying in the global economy. As soon as the stimulus from declining oil prices is exhausted, the current business cycle could turn down decisively.
The most important headwind for growth is the deflating of the property bubble almost everywhere. Because interest rates are still low despite the 12 Fed rate hikes, property deflation seems to be at a slow pace, which is not yet alarming financial markets. I think the situation will be quite different by mid-2006.
First, the slow-motion deflation of a property bubble will bite over time in any case. There should be enough time to convince property owners that they are holding a depreciating asset by mid-2006, which would change their consumption behavior. The consumption momentum in the US could turn sluggish.
China's property bubble is beginning to deflate. While construction is still rising rapidly despite sluggish sales, it should slow or even decline by mid-2006 as inventories pile up. The slowing trend could accelerate by then, which could bring down China's investment growth rate sharply.
Second, global liquidity should begin to decline by that time. The Fed rate hikes have had a limited effect on global liquidity because financial markets can tap into the plentiful liquidity in Europe and Japan. One by-product of this trend is the decline in the euro and the yen. The availability of alternative sources of liquidity has reduced the effectiveness of the Fed rate hikes.
As the dollar strengthens, the effectiveness of alternative liquidity will decline and global liquidity tighten. Furthermore, by all indications, the ECB and BoJ should have begun to tighten by mid-2006. Global liquidity could drop sharply by that time. This could cause the risk appetite in the world to decline significantly.
The rise in risk appetite in financial markets has been at the heart of the global economic resilience in recent years. The proliferation of innovative mortgage products, hedge funds, private equity, and Wall Street proprietary trading has sharply decreased the cost of capital for physical investment or financial speculation.
There has been a close correlation between the increase in risk appetite and decline in interest rates, making monetary policy more potent than usual in this cycle. This has been the principal reason for the numerous bubbles that have elevated global growth. As monetary conditions reverse, the risk appetite may reverse also. Many financial bubbles could deflate in 2006, bringing down the global growth rate.
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