Like Driving With the Emergency Brake On

 | May 05, 2012 | 2:30 PM EDT  | Comments
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Energy prices declined dramatically Friday following the release of the employment report (PDF) by the Bureau of Labor Statistics. Oil prices are off by 4% for West Texas Intermediate and by 3.25% for Brent crude. Natural gas prices are also down by around 2.5%.

The 10-year Treasury yields in the U.S. and Germany each sank by about 5 basis points today, as well, respectively to 1.88% and 1.58%. These are yields that would have been associated only with Japan just a few years ago. European equities also dropped dramatically following the release, with most indices falling some 2%.

The consensus among the global market participants for stocks, bonds and commodities appears to be that they don't like what the data in the employment report imply about the near-term prospects for the U.S. economy. Some, however, will focus on the near-term potential for falling energy prices to engender declining gasoline prices, and thus to become a catalyst for an increase in confidence. But this is a sliver of hope that also implies risks to the global economy.

Oil prices are increasingly getting bracketed between two concepts, with an economically viable range between the highs and lows shrinking to a convergence point -- one that, for practical purposes, has already been met.

The low end of the price range -- $95 per barrel today and climbing -- is set by the revenue per barrel Saudi Arabia needs to receive in order to meet its government spending mandates, principally for social welfare programs and debt service. The top end of the range is set by the level at which oil consumption produces a net drag on economic activity termed "uneconomic growth." That level is in the $100 range.

If oil falls below $95, the revenue produced for Saudi Arabia will be below the country's spending requirements, in view of its existing output. This can be bridged with debt for a short period, but not with spending cuts. Most people are wholly unaware of this, and instead focus on the low cost of production from Saudi fields as opposed to that in other areas of the world.

The 2012 breakeven price of $95 is an increase from $80 in 2011 and just $50 in 2008. This jump is due to the increased social costs the Saudi government has implemented in order to prevent the Arab Spring uprisings of 2011 from toppling its own government, and this necessary spending is now likely to be structural and permanent -- not temporary.

If the oil price falls below these levels for an extended period due to a Chinese or global recession, Saudi Arabia's borrowing costs will rise and prevent the country from meeting its spending needs. That, in turn, could set the stage for an Arab Spring-style uprising there.

However, even less well-known is that the economic ceiling for oil prices is also at about current prices. As oil prices rose above $100, the global economy entered a zone known as uneconomic growth -- in other words, growth that costs more than what it produces. It is difficult to measure uneconomic growth because accounting systems are not designed for it.

For an example of this, China is building ghost cities -- entire cities that, once built, remain empty. Yet these cities have a building cost and maintenance expenses, or ongoing costs associated with them, without any resulting increase in economic activity. The building is reflected in an increase in GDP, but there is no multiplier. Capital and oil have been consumed, and have increased the necessity to consume them both further.

Here's an analogy I use to explain the concept of uneconomic growth. When I was a runner -- almost three decades in the Marine Corps -- my knees starting wearing out. My corrective response was to self-medicate before a run with an increasing number of pills of Advil. I did this until I got to the point at which I needed to take 10 Advil just to run a few miles. Any physical or health gain I received by running in that way was more than offset by the increased damage to my knees, as well as that to my organs as they processed the painkillers.

In terms of the global economy, the symptoms won't be as obvious, but they will exist. Oil prices rise due to an increase in consumption, which causes the rate of consumption to increase, which causes the price to increase even further. As all of this occurs, an economic conundrum will increasingly become exhibited as a reduction in the rate of real global economic activity.

As this phenomenon begins to emerge, we should start seeing public discussion of this issue by economists all over the world very soon. Unlike the immediate situation facing Saudi Arabia on the low end of oil prices, however, this process will go on for years as economists debate this issue, since uneconomic growth is so poorly understood by policymakers.

From the perspective of measuring economic activity, the best analogy I can think of this: It will be like the sensation you get when you are driving your car with the emergency brake on. Until it occurs to you that the brake is on, it just seems that the car's performance is sluggish, even as you increase pressure on the throttle.

Once we're aware of this uneconomic growth, however, the immediate corrective resolution will be to reduce the cost of oil through technology. The problem with this, howevever, is that such actions cause consumption to increase again.

This is all a part of the peak oil debate that has yet to resonate with the markets. It's not about whether there's oil. It's about whether oil is economically viable.

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