Alan Greenspan caused a stir last week with the contention a "significant correction" for stockmarkets may not be too far in the distance, but his largely unnoticed insights into the oil market offer central bankers plenty more to worry about given the spectre of deflation in developed economies.
Greenspan, who led the US Federal Reserve for a staggering 19 years, asserts the near-term outlook for the price of ‘black gold’ is potentially as dark as the commodity itself amid a build-up of surplus capacity in key markets.
The result is current prices that may be 20 per cent north of where they should be, in part due to rising geopolitical tensions.
Should conflicts even partially calm down in the Middle East -- and Ukraine -- then the oil majors could be in for a rude shock, while central banks will have their work cut out staving off the threat of deflation.
“We have a very significant amount of excess capacity and slack,” he noted, specifically pointing to Saudi Arabia and Kuwait.
“Were it not for the [geopolitical] problems, I think crude oil prices would be down $15 to $20 a barrel from where (they are).”
Currently, prices stand around $US97 a barrel for US West Texas Intermediate (WTI) and $US105 for Brent crude, having drifted nearly 10 per cent off the 2014 highs set just 6 weeks ago when fears over the insurgency in Iraq were at their peak.
The potential for further falls was underlined overnight as US crude slumped to a fresh six-month low despite rising fears of a Russian invasion of Ukraine.
The latest pricing setback follows a month after the US benchmark oil contract quietly experienced one of its worst runs in history, with nine straight sessions in the red. If the falls had extended to 10 days, it would have represented the longest losing streak for three decades during what was otherwise a sustained period of calm for global markets.
Greenspan is adamant this is a sign of things to come, noting the persistent downward trend since oil prices reached their peak in June is recognition of supply-demand imbalances.
“I think that the markets are making an adjustment, but I don’t think the news media has really adjusted to that,” he asserted.
A key factor in the retreat is consistent growth in US oil production due to the shale boom, which has further restricted the control on the market previously held by OPEC.
The last time OPEC’s market power faced such a threat -- the 1980s -- oil prices slumped from $US100 to $US30 a barrel in five years (in inflation-adjusted terms).
The result of swelling non-OPEC supply is a jump in spare capacity among OPEC members, which energy giant BP and the International Energy Agency predict will soon hit levels not seen since the early 2000s (and before that, the mid ‘80s).
History tells us that during times of significant spare capacity, OPEC has trouble controlling its members, with quotas regularly broken by a number of parties as oil prices turned sharply lower in the '80s.
During the two previous periods of surging spare capacity for OPEC members, oil prices drifted below $US40 in inflation-adjusted terms, less than half current levels.
The data indicate plenty of room for heavy price falls. If a near-term retreat of the ilk hinted at by Greenspan eventuates -- which would see a return of near-$80 oil -- the global battle against deflation will become even more delicately poised, with the eurozone particularly susceptible.
Oil prices, while no longer as correlated to inflation data as they were in the 1970s and ‘80s, still have a significant impact on prices due to heavy consumption in the supply chain as well as use at the pump.
The last time oil price falls of the $20-$30 per barrel magnitude were seen in a short space of time was between July and October last year, when noticeable disinflation was recorded in key global markets. In Europe, inflation slipped from 1.6 per cent to 0.7 per cent and has not since recovered; in the US, inflation dipped from 2 per cent to 1 per cent over the same period.
Since 2012, there have been two other occasions of similar oil price slumps that brought the price of the commodity back towards the $80 level. On each occasion, the impact on inflation was evident.
From February to April last year, eurozone inflation slipped from 1.7 per cent to 1.2 per cent as Brent crude retreated 20 per cent. At the same time America’s inflation rate fell from 2 per cent to 1.1 per cent. While between March and July 2012, the inflation rate in the eurozone declined from 2.7 per cent to 2.4 per cent and the US CPI slumped from 2.7 per cent to 1.4 per cent as oil prices drifted nearly 30 per cent off highs.
In all cases, energy prices were seen as the largest contributor to disinflation, with the eurozone’s inflation rate only holding up in 2012 due to a 10 per cent collapse in the value of its currency compared to its US counterpart.
Currently, annual inflation for the eurozone rests at a very precarious 0.4 per cent, which leaves a big oil question mark hanging over the ECB’s push to stave off deflation.
With signs of distress emerging in the wake of the near-collapse of a Portuguese bank and Italy’s return to recession, it’s not hard to see a deflation event on the horizon, causing stress for policymakers who, as Alan Kohler pointed out on Tuesday, are now more obsessed with the risk of deflation than the threat of inflation.
Indeed, a negative oil price shock would only serve to make cautious, ‘behind the curve’ central bankers even more wary, with the ECB’s Mario Draghi required to dig further into his expanding bag of tricks and the US Federal Reserve granted more leeway to hold off on rate rises until the back half of next year.