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Charles Hugh Smith

Charles Hugh Smith

Charles Hugh Smith has been an independent journalist for 22 years. His weblog, www.oftwominds.com, draws two million visits a year with unique analyses of global…

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An Update to the Oil "Head-Fake" Scenario

With the world teetering on the edge of another global financial meltdown, it's a good time to revisit my May 2008 Oil "Head-Fake" Scenario.

In May 2008 I proposed the Oil "Head-Fake" Scenario in which global recession will drive oil demand down even as oil exporters pump their maximum production in a futile attempt to fund their vast welfare states and thus retain their precarious political power.

Oil: One Last Head-Fake? (May 9, 2008)

The terrible irony of the head-fake, of course, is that the exporters' mad efforts to pump more oil merely exacerbates the oversupply, further depressing prices, which are set on the margin. As exporters receive fewer dollars for their production, they attempt to compensate by pumping even more oil. Perniciously, this suppresses prices even more, setting up a positive feedback loop which pushed prices into full-blown collapse.

At the same time, the majority of exporting nations will continue under-investing in their oil production and exploration infrastructures, essentially dooming them to future depletion and potentially even collapse of production.

This cycle of spending the fruits of current production while starving investment for the future is part of what is known as the "resource curse:" nations with an abundance of resources rely on the income generated by the sale of their resources which effectively stunts the development of a diverse economy and the institutions which such a diverse economy requires as a foundation.

The net result of the resource curse is national impoverishment as the resources are depleted. Diverting the vast majority of the oil revenues to support welfare states and Elites further dooms the oil exporters to under-investment in future production. All this will play out after the head-fake oversupply vanishes; then production in the strip-mined oil exporting nations will plummet with surprising ferocity.

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Commodities tend to be priced on the margin. If oil production falls 2% below demand, prices don't rise 2%; they might rise 20% because demand for oil is not very elastic. This "pricing on the margin" is even more visible in grains. Small shortages can leverage up huge price increases.

Global governments borrowed, printed and spent trillions of dollars in "stimulus" and "quantititative easing" in 2009 and 2010. This unprecedented influx of money, combined with zero-interest rate policies (ZIRP) and tens of trillions of bailouts, guarantees and subsidies shoveled into the financial and housing sectors have provided the comforting illusion that the zombie global economy is actually still moving under its own power.

That illusion is about to shred, exposing the ugly reality of global depression as credit bubbles burst, taxes increase, and government spending dries up. Demand for oil will plummet accordingly, and oil exporting nations will have to make up the decline in their earnings by pumping every last barrel of production.

Even though Peak Oil is almost upon us--that is, global production will reach a maximum and then begin declining, regardless of what new fields are brought on-line-- the sudden drop in demand will cause prices to collapse to seemingly "impossible" levels. I am guessing $25/barrel as a floor, but even $10/barrel is not as "impossible" as standard-issue pundits may believe.

The world is already awash in surplus oil, and the current price around $80/barrel is largely the result of speculation as punters, traders and players turn to oil as a hedge against inflation. As deflation ravages assets, government budgets and revenues, the hedge against inflation might not be powerful enough to support the speculative premium currently priced into oil.

Here are the relevant Peak Oil charts:

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Oil Production

Oil and Gas

And here is the updated "head-fake" chart:

Oil "Head Fake"

We should know by 2012 if my "head-fake" scenario will play out as forecast.

Other notes: Peter at electricbikeworks.com offered this comment on yesterday's entry Cheap Oil: The Engine of america:

Regarding your dig on electric bikes and cheap oil. The vast majority of electric bike rides (in the US) are replacing car trips not bike trips.
The typical electric bike owner (in the US) is a boomer easing into fitness and is pedaling more than he has in years.
Go for an electric bike ride, I guarantee it will put a smile on your face!

As I explained to Peter in an email, my intention was not to slam electric bikes but to point out that every manufactured item, even an electric bike, consumes large amounts of energy in its manufacture, and that any transportation which requires electricity or fuel requires a massive energy infrastructure (or solar arrays, windmills, tidal generators, etc. which also require huge energy inputs for their manufacture, delivery, maintenance, etc.)

Charles Hugh Smith has been an independent journalist for 22 years. His weblog, www.oftwominds.com, draws two million visits a year with unique analyses of global finance, stocks and political economy. He has written six novels and Weblogs & New Media: Marketing in Crisis and just released Survival+: Structuring Prosperity for Yourself and the Nation.


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