The most immediate evidence of the break point would be in the decisions by energy users—whether large industrial firms, which found new ways to reduce energy use; or airlines, which cut back on the number of planes in the air; or individual consumers, who could change their behavior.
And that consumers were doing. They were driving less. In June 2008 California motorists used 7.5 percent less gasoline than in June 2007. Consumers were also voting with their feet. They were no longer walking into auto showrooms, and when they were, they were steering clear of SUVs. They wanted fuel-efficient vehicles, if they wanted anything at all. That left Detroit, which had focused on the popular SUVs, scrambling to try to gear up to produce the cars that consumers now desired and that would meet the new fuel-efficiency targets—something that would take billions of dollars and several years to implement. The torrid romance with the SUV had suddenly gone cold. The oversize Hummers were becoming targets of vandalism.22
Meanwhile, oil companies were dramatically increasing their spending to develop new supplies, although they had to contend with the big increase in costs. The market was no longer tight. World oil supply in the first quarter of 2008 was more than a million barrels higher than it had been in the first quarter of 2007. In June 2008 U.S. oil demand was a million barrels less than it had been in June 2007. These prices were providing both a political and commercial stimulus to the longer-term development of renewables and alternatives.
CHANGING THE CAR FLEET
The turmoil in the market had a major impact on public policy and on the politics of energy, and nowhere more significantly than in regard to the American automobile.
The United States has the world’s largest auto fleet—about 250 million out of a global total of 1 billion. Despite growth in emerging markets, one out of every nine barrels of oil used in the world every day is burned as motor fuel on American roads. In 1975, during the first oil crisis, fuel-efficiency standards were introduced, requiring a doubling from the then-average of 13.5 miles per gallon to 27.5 miles per gallon over ten years. And there the standards sat for more than three decades, with some minor tinkering around the edges.23
But circumstances were changing. In his 2006 State of the Union Address, President George W. Bush denounced what he called the nation’s “addiction to oil.” And new players became engaged. The most notable group was the Energy Security Leadership Council, an affiliate of another group, SAFE—Securing America’s Future Energy. The council was chaired by P. X. Kelley, a former commandant of the Marine Corps, and Frederick Smith, the founder and CEO of FedEx. The members were retired military officers and corporate leaders, not exactly fitting the traditional mode of environmentalists and liberals who had traditionally campaigned for higher fuel-efficiency standards.
In December 2006 the council issued a report advocating a balanced energy policy. Raising auto-fuel standards was the first chapter. Five weeks later, to Detroit’s shock and notwithstanding opposition from within his own administration, Bush used his 2007 State of the Union to endorse a fuel-efficiency increase. A week later, Bush met with some of the council’s members. The president made clear the geopolitical thinking behind his energy policies. He wanted, he said, to get Iranian president Mahmoud Ahmadinejad and Venezuelan president Hugo Chávez “out of the Oval Office.”
The Council took its campaign to the Senate. At one hearing, council member Retired Admiral Dennis Blair, former commander of the Pacific Fleet (and later director of National Intelligence in the Obama administration), argued that excessive dependence on oil for transportation was “inconsistent with national security” and that nothing would do more than “strengthen fuel economy standards” to reduce that dependence.24
Fuel-efficiency standards were no longer a left-right issue. Now they were a national security and a broad economic issue. New standards flew though both houses of Congress. In December 2007, almost exactly one year to the day after the Energy Security Leadership Council’s report, Bush signed legislation raising fuel-efficiency standards—the first such increase in 32 years.
Of course, the new fuel-efficiency standards would take years to make a sizable impact. Automakers would have to retool, and then, in normal years, only about 8 percent of the vehicle fleet turns over annually. But when their impact was felt, it would be very large.
THE GREAT RECESSION
What was happening in the economy would also lower the demand for oil. The Great Recession, at least in the United States, is now reckoned to have begun in December 2007, well before most anybody had recognized it. It was primarily a credit recession, the result of too much debt, too much leverage, too many derivatives, too much cheap money, too much overconfidence—all of which engendered real estate and other asset bubbles in the United States and other parts of the world.
But the surge in oil prices was an important contributing factor to the downturn. Between June 2007 and June 2008, oil prices doubled—an increase of $66—in absolute terms, a far bigger increase in oil prices than had ever been seen in any of the previous oil shocks, going back to the 1970s. “The surge in oil prices was an important factor that contributed to the economic recession,” observed Professor James Hamilton, one of the leading students of the relation between energy and the economy. The oil price shock interacted with the housing slowdown to tip the economy into a recession. The sudden increase of prices at the pump took purchasing power away from lower-income groups, making it more difficult for many of them to make payments on their subprime mortgages and their other debts. The higher cost of the gasoline they needed to get to work meant trade-offs in terms of what else they could spend elsewhere. The effects also showed up, as Hamilton has noted, in “a deterioration in consumer sentiment and an overall slowdown in consumer spending.”
As gasoline prices rose, car sales nosedived. Discounting and rebates by auto dealers did little good. June 2008 was the worst month for sales for the auto industry in seventeen years.
“The auto industry was under siege,” said Rick Wagoner, the former CEO of General Motors. “While we had a comprehensive scenario planning process at GM, we had no scenarios in which oil prices went up so much, so fast. People weren’t coming into showrooms as oil prices skyrocketed in part because their disposable incomes were going down. The rate and size of the decline in auto sales was unprecedented. Demand was collapsing.” Wagoner continued, “The only question was how high oil prices would go and when they came down, to what level. Our view of the future was that it was either going to be difficult or very, very difficult.”25
The effects of the downturn in the automobile industry reverberated throughout the supply chains of companies that supplied it and at dealers across America. Many hundreds of thousands of jobs were abruptly lost across the economy.
The direct impact was felt less in other developed countries because so much of the price at the pump is actually tax. Many European governments use gasoline stations as subbranches of their treasuries. Thus while government tax on gasoline averages 40 cents in the United States, it is more like $4.60 a gallon in Germany. Thus a doubling in the price of crude oil would only raise the retail price in Germany by a fraction of what it would in the United States.
Many developing countries subsidize retail fuel prices; oil-exporting countries, generously so. To allow prices to rise would mean social turmoil and perhaps strikes and riots. Thus these governments had to absorb the growing gap between the world price for oil and the prices that their citizens paid. Subsidies cost India’s government about $21 billion in 2009.26
SOVEREIGN WEALTH
When it was all added up, these high prices transferred a great deal of income from consuming countries to producing countries. The total oil revenues of the OPEC countries rose from $243 billion in 2004 to $693 billion in 2007. Halfway through 2008, it looked as though it could reach $1.3 trillion.
What were they going to do with all this money? Part of the answer was embodied in the initials SWF, shorthand for “sovereign wealth funds.” These were essent
ially government bank accounts and investment accounts set up to receive oil and gas revenues that would be kept separate from the national budget. For some countries, they were cast as stabilization funds to be held for “rainy days.” Some funds were explicitly created to prevent inflation and the Dutch disease that can result from a resource boom. These funds transformed oil and gas earnings into diversified portfolios of stocks, bonds, real estate, and direct investment.
But with oil prices rising to such heights, they had become truly giant pools of capital, swollen with tens of billions of dollars of unanticipated inflows, and now with tremendous financial capacity that would have far-reaching impact on the global economy. They faced their own particular quandary—how to invest all these additional revenues in a timely and prudent fashion. But the flip side was that their expansion meant a very large reduction of spending power in the oil-importing countries, which contributed to the downturn.
THE PEAK
Still the spell held. On July 11, 2008, oil reached its historic peak of $147.27—many times higher than the $22-to-$28 band that had been assumed to be the “natural price” for oil only four years earlier. The headlines told of more economic troubles ahead: Then something did happen. “Shortly after 10 a.m., as Mr. Bernanke was speaking to Congress,” the New York Times reported on July 16, “investors did a double-take as oil prices, previously trading at record highs, suddenly plunged.” But, said the oil bulls, it was “only a minor meltdown.”27
And then the fever broke. Demand for oil was going down in response to the higher prices. And now it was going down for another reason too. The world economy was clearly beginning to slow. The United States was already in a recession. In China’s Guandong Province, the new workshop of the world, orders were drying up, exports were declining, and workers were being laid off. Even electricity demand in that formerly booming province was declining. That was a message with global implications, for it meant that world trade was contracting. And the world’s financial system was beginning to shudder and shake, the spasms of a coming cataclysm. Financial investors began ditching “risky” assets such as equities and oil and other commodities.
In September 2008 came the decisive event. The venerable Lehman Brothers, the fourth-largest U.S. investment bank, 158 years old, failed. No one came riding to its rescue. The insurance behemoth AIG looked as though it might go down the very next day; the Federal Reserve stepped in to save it at the last moment.
“A COLD WIND FROM NOWHERE”
In the aftermath of the Lehman collapse, the world’s financial system simply froze up. Finance stopped flowing, whether to fund the daily operations of major companies or to provide the lubricant for trade. The Great Depression of the early 1930s, which had seemed to belong distantly in history, something that happened a very long time ago, now seemed to have happened only yesterday. History books and economic texts were hurriedly scoured for immediate and urgent lessons on how to rescue a failing banking system. The crisis was turning into a global panic of the sort that had not been seen for many decades. The impact on what had been healthy economies, including the BRICs, was, as Federal Reserve Chairman Ben Bernanke said, like “a cold wind from nowhere.”
CRUDE OIL PRICES
Source: IHS CERA
U.S. GASOLINE PRICES
Source: IHS CERA
In the midst of what would become known as the Great Recession, demand for oil continued to decline while supplies continued to build up. Yet even in the week that Lehman collapsed, a prediction of “$500 per barrel oil” managed to make its way prominently onto the cover of a leading business magazine. At that moment, however, oil was heading down, and precipitously so. Before the year was out, as the tanks at Cushing, Oklahoma, ran out of storage space and crude backed up in the system, the price of WTI fell to as low as $32 a barrel.
Even though prices subsequently recovered, the spell had been shattered.
For some, prudence paid off, when prices came tumbling down. Indeed, there is no better example of the value to an oil producer of hedging its production forward than the sovereign nation of Mexico. Its government is very vulnerable to the price of oil, as about 35 percent of its total revenues are generated by Pemex, the state company. A sudden fall in the price of oil can create budgetary and social turmoil. For years, Mexico had been hedging part of its oil output. In 2008 Mexico went all out and hedged its entire oil exports and locked in a price. It was not cheap; the cost of this insurance was $1. 5 billion. But when the price plummeted, Mexico made an $8 billion profit on its hedge, thus preserving $8 billion for its budget that, without the hedge, would have otherwise disappeared. It could only have done that huge trade over the counter. If it had tried to do it on the futures market itself, the scale would have set off a scramble by other market participants before Mexico could even begin to get all of its hedges in place.
That transaction was, on Mexico’s part, an act of prudence but also audacity. On the basis of the transaction’s success, Mexico’s finance minister received a unique honor—he was dubbed the “world’s most successful, but worst paid, oil manager.”28
How much of what happened in the oil market can be ascribed to the fundamentals, to what was happening in the physical market, and how much to financialization and what was happening in the financial markets? In truth, there is no sharp dividing line. Price is shaped by what happens both in the physical and financial markets.29
A couple of years later, Robert Shiller, who had become prominent for calling the Internet stock bubble and then the real estate bubble, was having breakfast in the restaurant of the Study, a new hotel on Chapel Street in New Haven, before walking over to lecture in his famous Yale class on financial markets. By then, with recovery well along in the global economy, the price of oil had more than doubled from its lows back to a range of $70 to $80 a barrel. Handed a piece of paper, Shiller looked carefully at what it showed—a plot depicting the movement of oil prices since 2000 culminating in the sharp ascent to its peak in mid-2008, and then its precipitous fall. It was superimposed on a plot of stock prices that culminated in the market boom that went bust in 2000. The fit was very tight. The two curves looked very similar. But the steep, bell shape of the curve instantaneously reminded Shiller of something else as well.
“That looks very much like what happened with real estate prices,” he said. A bubble.30
The rise in oil prices had not begun as a bubble. For the price had been driven by powerful fundamentals of supply and demand; by the demand shock arising from unexpectedly strong global growth and major changes in the world economy, led by China and India; and by geopolitics and the aggregate disruption. But it was a bubble before it was over.
9
CHINA’S RISE
It was one of those sharp, cold nights in Beijing when the smell of burning, crisp and a little sweet, wafted through the dark. This was the very end of the 1990s when the swelling hordes of cars were beginning to fill the new eight-lane highways and push the bicycles to the side. The burning still mainly came not from the cars but rather from the many hundreds of thousands of oldfashioned coal ovens throughout the city that people were still using to cook and heat their homes.
The dinner had gone on for a long time in the China Club, once the home of a merchant, and then a favorite restaurant of Deng Xiaoping, who had launched China’s great reforms at the end of the 1970s. Coal may have been in the air that night, but oil was on the agenda. With the dinner over, the CEO of one of China’s state-owned oil companies had stepped out into the enclosed courtyard with the other guests. Everybody’s overcoats were buttoned to the top against the cold. He and his management team were facing something he would never have anticipated when he started as a geologist in western China, more than three decades ago. For now they were charged with taking a significant part of China’s oil and gas industry—built to serve the command-and-control centrally planned economy of Mao Tse-tung—and turning it into a competitive company that would meet the listing requirem
ents for an IPO on the New York Stock Exchange.
The reasons for this sharp break with the past were clear—the specter of China’s future oil requirement and the challenge of how to meet it—although that evening they could not visualize how rapidly consumption would grow. As the group paused in the courtyard outside the restaurant, the CEO was asked a pertinent question: Why go to all the trouble of becoming a public company? For then the management would be responsible not only to the senior authorities in Beijing but also to young analysts and money managers in New York City and London, and in Singapore and Hong Kong , all of whom would scrutinize and pass judgment on strategies, expenses, and profitability—and on the job they all were doing.
It wasn’t at all obvious that the CEO relished such an “opportunity.” But he replied, “We have no choice. If we are going to reform, we have to benchmark ourselves against the world economy.”
That was still the time when China was moving from being a minor player in the world oil market to something more, although how much more was not at all clear. What was clear, however, was that China was fast integrating with the world economy and beginning to transition to a new and far larger role in it.
Over the years that followed, these changes would transform calculations about the world economy and the global balance of power. Would all of this mean a more interdependent world? Or, people would ask in the years to come, would it lead to intensified commercial competition, petro-rivalry, and a growing risk of a clash of nations over access to resources and over the sea-lanes through which those resources are borne?
The Quest: Energy, Security, and the Remaking of the Modern World Page 22
