Sunday, May 18, 2008

Economics Forecasting and the Irish Economy as oil price heads for $200 a barrel

Economics and financial forecasts have a dubious reputation for a reason.

In both finance and economics, just consider the record of the pundits from Fed Chairman Ben Bernanke and ex-Goldman Sachs head Hank Paulson, currently US Treasury Secretary to the legion of "experts" presented on CNBC, the US business television network, in the months following the news of subprime troubles in February 2007. Some were foolish in proclaiming "containment" when they should have known better. Most were involved in self-interested wishful thinking.

Goldman Sachs made money from subprime on the way up and down as it did not follow the consensus on the way down.

When its partytime, economists who are dependent wage slaves, have to play the game of optimism and forecasts tend to revolve around a consensus figure and it can take several adjustments to a more realistic forecast.

In the UK, during the tech boom, fund manager Tony Dye who was known as "Dr Doom," was well known for many years as the successful chief investment officer of the fund managers Phillips and Drew. However, he refused to follow investor fashion by buying shares in companies, fearing a slump in the markets was imminent. He lost his job and both he and legendary US investor Warren Buffett were proved right.

In Ireland, bank economists tend to be the optimists as retail products such as mortgages have to be supported. Stockbrokers such as Davy and Goodbody have a more credible track record. Although Alan McQuaid, Chief Economist of Bloxham Stockbrokers held out the prospect of an ECB rate cut in September 2007 and wrote in the Irish Times: "I'm sick to death of people writing off the Irish economy and next year could easily see the "Celtic Tiger" roaring more loudly than many pessimists think."

This was just months after then Taoiseach Bertie Ahern, told people who were engaged in "cribbing" from the sidelines, to "commit suicide."

It was also a time, when the new Minister for Education Batt O'Keeffe, then Minister for Housing, said that it was a good time for intending first-time house buyers, to purchase.

It should be remembered that the "sky is falling" pundits were easily outranked by the cheerleaders peddling snake oil.

The Economic and Social Research Institute (ESRI), which as an independent institute on public funding, was the inspiration of the architect of the modern Irish economy T.K. Whikaker, was regarded as too pessimistic last year about the prospects of the Irish economy in 2008.

This week, the ESRI issued its biennial Medium Term Economic Review and in contrast with the European Central Bank (ECB) which provides a forecast range, one figure was published for the forecast and provided a good headline for the Irish Government, but the spin ran-ahead of the story.

The Irish Independent reported that : Taoiseach Brian Cowen got unexpected good news on the economy last night when a major report predicted it would bounce back in time for the next general election.

Forecasting a major comeback in growth by 2010, the country's leading economic think-tank said the economy will grow by an average of 3.75pc annually between now and 2015.

The Economic and Social Research Institute (ESRI) medium-term review, published every two years, is optimistic about the country's economic prospects and predicts a return to full employment within a few years.

Throwing down the gauntlet to Brian Cowen and new Finance Minister Brian Lenihan, the report says that when the current slowdown ends, the economy should recover rapidly -- but only if proper policies are put in place.

New Minister for Finance Brian Lenihan commented: “It is encouraging to see that the ESRI’s view that the medium term prospects for the Irish economy are generally positive. Based on their analysis, real growth in GDP of 3¾ per cent per annum is sustainable over the medium term. This rate of growth is much higher than elsewhere in the euro area. In contrast to the prevailing mood of pessimism, the ESRI shares my view in that we should see a return to trend growth from 2010 onwards. I share the view that economic conditions in 2008 and 2009 will remain weak and that sensible policies be pursued. The Government remains determined to press ahead with our Infrastructural Development programme. Discipline on current expenditures under all headings will be critical over the next few years given the changed resources available.

The key message that we can take from the Review is that Ireland’s economy is flexible and resilient. Because of our sound economic and fiscal fundamental factors, our economy has the ability to absorb shocks in an efficient manner; to limit the economic fall-out and to return to its trend rate of growth fairly rapidly.”

There was no mention of the downside scenario in the report.

Assumptions on energy prices are derived from the International Energy Agency’s (IEA) forecasts. However, it raises a key issue on the reliability of the outlook as the IEA forecasts are not recent ones.

The oil price is forecast at $73.9 in 2012.

Earlier this month, the US Energy Department said that the US oil benchmark WTI (West Texas Intermediate) which averaged $72 per barrel in 2007, is projected to average $110 per barrel in 2008 and $103 per barrel in 2009.

The IEA said in its market report last July, that despite four years of high oil prices, it expected increasing market tightness beyond 2010, with OPEC spare capacity declining to minimal levels by 2012. A stronger demand outlook, together with project slippage and geopolitical problems has led to downward revisions of OPEC spare capacity by 2 mb/d in 2009. Despite an increase in biofuels production and a bunching of supply projects over the next few years, OPEC spare capacity is expected to remain relatively constrained before 2009 when slowing upstream capacity growth and accelerating non-OECD demand once more pull it down to uncomfortably low levels.

As to the oil price being $90.5 in 2020 according to the ESRI, the projection appears to be very much out of date.

Assumptions on energy prices are derived from the International Energy Agency’s (IEA) forecasts. However, it raises a key issue on the reliability of the outlook as the IEA forecasts are not recent ones. ESRI Medium-Term Review 2008-2015: Irish economy to grow at 3.75% annual rate; Business services exports very sensitive to Ireland’s competitiveness

Last November, in the Finfacts report on the World Energy Outlook 2007 (Check links in Related), we said: With the price of crude oil heading for the $100 a barrel benchmark, having risen in dollar terms by 61% and 45% in euro terms since January 2007, the International Energy Agency (IEA), the adviser to 26 industrialised countries including Ireland, said today that the world's primary energy needs are projected to grow by 55% between 2005 and 2030, at an average annual rate of 1.8% per year. Chinese and Indian crude oil imports will almost quadruple by 2030, creating a supply ``crunch'' as soon as 2015.

Before returning to the oil issue, the forecast that business service exports will rise to 70% of total exports, also raises an issue that is not covered in the report.

Companies with a small number of staff, could book huge amounts as Irish sales. One of the biggest companies operating in Ireland is Microsoft's Round Island One and it has no staff. It operates from the offices of a Dublin Law firm.

New York Times columnist Paul Krugman, who has another job as a professor of economics at Princeton University, wrote in early May: "The Oil Bubble: Set to Burst?” That was the headline of an October 2004 article in National Review, which argued that oil prices, then $50 a barrel, would soon collapse.

Ten months later, oil was selling for $70 a barrel. “It’s a huge bubble,” declared Steve Forbes, the publisher, who warned that the coming crash in oil prices would make the popping of the technology bubble “look like a picnic.”

Krugman wrote that all through oil’s five-year price surge, which has taken it from $25 a barrel to last week’s close above $125, there have been many voices declaring that it’s all a bubble, unsupported by the fundamentals of supply and demand.

So here are two questions: Are speculators mainly, or even largely, responsible for high oil prices? And if they aren’t, why have so many commentators insisted, year after year, that there’s an oil bubble?

Krugman says that the only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding — an increase in private inventories of black gunk. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling.

But it hasn’t happened this time: all through the period of the alleged bubble, inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn’t the result of runaway speculation; it’s the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China. The rise in oil prices these past few years had to happen to keep demand growth from exceeding supply growth....Saying that high-priced oil isn’t a bubble doesn’t mean that oil prices will never decline. I wouldn’t be shocked if a pullback in demand, driven by delayed effects of high prices, sends the price of crude back below $100 for a while. But it does mean that speculators aren’t at the heart of the story.

The consequences of that scarcity probably won’t be apocalyptic: France consumes only half as much oil per capita as America, yet the last time I looked, Paris wasn’t a howling wasteland. But the odds are that we’re looking at a future in which energy conservation becomes increasingly important, in which many people may even — gasp — take public transit to work.

I don’t find that vision particularly abhorrent, but a lot of people, especially on the right, do. And so they want to believe that if only Goldman Sachs would stop having such a negative attitude, we’d quickly return to the good old days of abundant oil.

Again, I wouldn’t be shocked if oil prices dip in the near future — although I also take seriously Goldman’s recent warning that the price could go to $200. But let’s drop all the talk about an oil bubble.

Financial Times columnist Gideon Rachman wrote this week: Competition for the world’s oil supplies is intensifying. Chinese oil consumption doubled between 1994 and 2003 and will have doubled again by 2010. China’s foray into Africa is largely driven by its own search for “energy security”. The International Energy Agency predicts that in 2010 China will become the world’s largest consumer of energy. The IEA also thinks that the world’s energy needs will be 50 per cent higher in 2030 than they are today – and that we are going to become more, not less, reliant on fossil fuels.

This seems all too plausible. At present there are about 10 cars in China for every 1,000 people; there are 480 cars per 1,000 people in the US. But by 2015, China could be the world’s largest market for new cars.

Here are three facts about oil: it is a finite resource; it drives the global transport system; and if emerging economies consumed oil as Europeans do, world consumption would jump by 150 per cent. What is happening today is an early warning of this stark reality. It is tempting to blame the prices on speculators and big bad oil companies. The reality is different.

FT economics columnist Martin Wolf wrote: Demand for oil grows steadily, as the vehicle fleets of the world expand. Today, the US has 250m vehicles and China just 37m. It takes no imagination to see where the Chinese fleet is headed. Other emerging countries will follow China’s example.

Meanwhile, spare capacity in members of the Organisation of the Petroleum Exporting Countries is currently at exceptionally low levels, while non-OPEC production has equally consistently disappointed expectations.

It looks increasingly hard to expand supply by the annual amount of about 1.4m barrels a day needed to meet demand. This means an extra Saudi Arabia every seven years. According to the International Energy Agency, almost two-thirds of additional capacity needed over the next eight years is required to replace declining output from existing fields.

The oil price will provide the response to climate change not filling a laundry list with feeble initiatives.

In the meantime, what about a forecast with a more realistic average oil price - say in the range $150-$200?