Neoclassical economics cannot explain the spike in real global wealth per capita (nearly 10x) in the 20th century. The classic Cobb-Douglas Model attempts to explain global GDP growth through three major inputs: 1) “Total factor productivity,” 2) labor (L), and 3) capital (K). Both L and K can be quantified and explained. However, studies have shown that fully 70% to 80% of the increase in economic output during the 20th century came from “total factor productivity,” i.e. an exogenous factor that resembles technological growth and adoption—leading to increased overall productivity. Economists have a hard time explaining the origin of “total factor productivity.” We know that education (investment in human capital), venture capital, the capitalist system, and the sharing of ideas all play a role, but we do not truly understand why their benefits were unique to the 20th century (and to a lesser extent, the 19th century, when real global wealth per capita grew by 3x—please request a copy of our January 2013 newsletter for a more detailed analysis).
What we do know is that the vast majority of global economic growth in the 20th century was predicated on an exponential increase in energy consumption. In other words, productivity growth—20th century’s main economic driver—was mostly a result of increasing energy consumption. Every technological breakthrough, such as modern-day jets, computers, fiber optics, automobiles, etc. required the consumption of increasing amounts of energy. In some areas, we have made efficiency breakthroughs (e.g. the shrinkage of CPUs), but in other areas, not so much (e.g. the internal combustion engine). Such growth is especially amazing given the mass human failures of the 20th century, such as World War I & II, the rise of communism and Nazism, as well as the Korean and Vietnamese Wars. More important: If the 21st century global economy is to grow in the same trajectory as that of the 20th century, global leaders will need to find cheaper and alternative sources of energy—horizontal drilling and fracking notwithstanding.
In the meantime, global economic growth is still dependent on the consumption of fossil fuels, with crude oil being our main transportation fuel. As such, it is reasonable to conclude that—despite the increase in U.S. oil production—a rising global economy will lead to higher crude oil prices (China just surpassed the U.S. as the number one oil importer). A prediction for future oil prices thus requires an analysis of the performance of the global economy, given the globalized nature of oil. Using the Leading Indicators data for 30 major countries in the Organization for Economic Co-operation and Development (OECD), along with China, Brazil, Turkey, India, Indonesia, and Russia, we have constructed a “Global Diffusion Index” which have historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall. We label it the “CB Capital Global Diffusion Index” (“CBGDI”), which is essentially an advance/decline line of the OECD leading indicators—smoothed on a three-month moving average basis. Historically, the rate of change of the CBGDI has led WTI crude oil prices by about three months, with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (not surprising, since stock prices are one component of the OECD Leading Indicators). Following is a monthly chart showing the year-over-year % change in the CBGDI, and the rate of change (the 2nd derivative) of the CBGDI, versus the year-over-year % change in the MSCI All-Country World Index and the year-over-year % change in WTI crude oil prices from March 1990 to February 2013. All four of these indicators have been smoothed on a three-month moving average basis:
As noted on the above chart, the rate of change (second derivative) in the CBGDI (red line) has historically led the YoY% change in WTI crude oil prices by about three months. The major exceptions have been 1) the relentless rise in WTI crude oil prices earlier last decade (as supply issues came to the forefront), and 2) the explosion of WTI crude oil prices during the summer of 2008, as commodity index funds became very popular and as balance sheet/funding constraints prevented producers from hedging their production. The second derivative of the CBGDI troughed at the end of 2011, and has continued to rise—implying higher global stock and energy prices. While we recognize that U.S. crude oil production is set to rise by 1.4 million bbl/day over the next two years (not a trivial amount, as 1.4 million bbl/day is equivalent to total Indonesian oil consumption), recent strength in the CBGDI suggests that WTI crude oil prices have at least bottomed, for now. More important–unless celllulosic ethanol or second-generation biofuels are commercialized in the next several years (or unless room-temperature superconductors are discovered tomorrow)–this suggests that the secular bull market in oil prices is not over.
As we are finalizing this commentary, we understand that Cyprus may be experiencing a bank run, as the EU had suggested taxing bank deposits to pay for the country’s bailout. If implemented, this will set a very bad precedent and will have long-term (adverse) repercussions in the European banking system. Such a Black Swan scenario may weaken commodity and energy prices in the short-run, but we believe WTI crude oil is a “buy” on any further price weakness.