2012: Terra incognita

Predicting the future is never easy, but as I contemplate what 2012 might bring, I confess that it’s never been harder.

In 2005, it was fairly easy to see that commodity prices would rise in the coming years, and that the purveyors of petro-Prozac who dominated the press were wrong. It was evident in the data, particularly on oil. My outlook was generously validated up through the first half of 2008. While I expected a significant correction in housing prices and equities, I underestimated the magnitude of the late-2008 crash in the financial markets. Only a few observers who paid close attention to arcane derivatives markets got that one right.

In the fall of 2009, I made some outlier calls for 2010 on oil, equities, the US dollar, and China, all of which proved correct. I attribute that in part to luck, but mostly it was the result of having done my homework and developing a fine-tuned contrarian view.

Then it got more difficult.

In the fall of 2010, I was having a long email discussion with some fellow peak oil analysts about our outlooks for oil supply, trying to identify when the next big oil price spike might occur. After working over several detailed models of OPEC and non-OPEC supply, I snipped irritably that oil prices would likely be affected far more by above-ground factors in the next few years than below-ground factors. Geopolitics would soon trump geology, I ventured, and we would do well to pay attention to the news overseas. One well-placed bomb, another big hurricane in the Gulf of Mexico, a civil war in the Middle East, or any number of other events could blow our carefully constructed mathematical models out of the water.

But even I did not anticipate how radical the upsets of 2011 would be. No one could have predicted the earthquake and devastating tsunami that struck Japan on March 11, or foreseen how wide-ranging its effects would be: from shutting down automobile manufacturing plants, to record grid power prices in Hawaii, to several of the world’s most advanced economies turning their backs on nuclear power. We had plenty of advanced warning that weather would become more erratic due to climate change, but a record 12 natural disasters in the U.S. costing $1 billion or more, each, was an eye-opener. And I don’t think anyone expected the Arab Spring. It was a tough year for dictators.

Geopolitical challenges for fossil fuels

Above all, what jumps out of my crystal ball about 2012 is geopolitical instability. The popular unrest we saw worldwide this year feels like a mere prelude to a very chaotic period.

As an example, consider the slew of threats that currently imperil the global oil market:

• On December 16, a months-long peaceful protest by striking oil workers in Kazakhstan exploded into violence. Somewhere between 14 and 64 people were killed by police over the following weekend (depending on whether you believe the official count or a report from the morgue) in a harsh government clampdown which included shutting off all Internet and telephone access, and cordoning off the city. (Steve LeVine has been doing some terrific coverage of the events there for Foreign Policy.) The echoes of the Arab Spring are unmistakable. With about 1.6 million barrels per day (mbpd) of oil production, Kazakhstan is the world’s 18th-largest oil producer, on par with Libya’s output before the uprising there added about $10 to the global price of oil.
• Fresh waves of unrest in Syria could lead to civil war and seriously destabilize the already-tenuous oil trade in the Middle East. Oil production there has fallen from over 400,000 barrels per day in 2010 to 260,000 bpd now, in part due to EU sanctions. And Egypt is still very much in play in the region.
• Sanctions are likewise behind heightened tensions with Iran, as the US and EU forbid domestic and foreign partners from doing any business with the country in continuing efforts to stymie its nuclear ambitions. Iran conducted naval war game exercises near the Straits of Hormuz last week in retaliation, an implicit warning that it would attempt to shut down the critical Persian Gulf oil trade chokepoint if hostilities increase. And yesterday, they made that warning explicit, as Vice-President Rahimi said, “If Iran oil is banned not a single drop of oil will pass through Hormuz Strait.” Iran’s primary oil buyers, including China, Japan, Korea, and India appear to be seeking alternate supplies, but that will support oil prices globally as competition increases for oil from OPEC producers, notably Saudi Arabia.
• The situation in Iraq deteriorated almost immediately upon the exit of US military forces, with fighting between Sunni and Shiite leaders within the fledgling central government threatening its dissolution. A barrage of attacks in Baghdad over the last week portend continuing violence and instability, and do not bode well for the future of oil supply in the region.
• Tens of thousands of protestors jammed the streets of Moscow on Christmas Eve, jeering the Kremlin over widely alleged fraud in the recent election which retained Prime Minister Vladimir Putin’s grip on power. Russia was the largest oil producer in the world at the beginning of 2010, and now stands just below Saudi Arabia with 10.3 mbpd of production. Were it not for Russia, non-OPEC oil production would have been in steep decline for the last several years, and as such it remains a critical pillar of stability for world oil markets. . . a pillar which may now be eroding.

Though little reported in the American press, popular protests are on the rise in China as well. With a major turnover in leadership scheduled for 2012, there is at least the potential for significant reforms favorable to the country’s burgeoning middle class, who are growing increasingly restive under the suppression of its central government. But there is also the potential for renewed attempts to reinforce authoritarian rule. In the province of Guangdong in the south of China last week, tens of thousands of residents participated in two separate protests against the local governments over land policy and a planned expansion of a coal-fired power plant in the smog-choked town of Haimen. With the largest GDP of any province in China due to its heavy manufacturing base, Guangdong may be considered a leading indicator of China’s direction, more oriented to its trading partners to the west than to Beijing. Local authorities capitulated to the demands of the Haimen protestors, but only after police used tear gas to quell the demonstration. In short, China looks like an interesting wild card in 2012 where popular unrest could explode, particularly if its economic growth slows significantly, as some observers expect, and/or if the protests in Russia become more strident.

Another interesting wrinkle with potentially far-reaching implications emerged on Christmas Day, as China and Japan announced that they would begin direct bilateral trading of their currencies. About 60 percent of the trade between the two nations is currently settled in US dollars, according to Japan’s Finance Ministry. Coming from the two largest holders of foreign-currency reserves in the world, the accord constitutes a potentially serious threat to the hegemony of the US dollar, which has conferred an enormous economic advantage to America for many decades. The pact is considered largely symbolic for now, but could signal the ascendancy of the renminbi, and will likely lead to continued weakening of the dollar against it. More broadly, the move could presage an entirely new era of geopolitical alliances.

Economic outlook

The economic front looks perilous indeed. It is certainly possible that 2012 will be another year of aimless bouncing around in a narrow channel while the world’s central banks keep trying to extend and pretend. With just three trading sessions left in a brutally difficult year that ruined many a seasoned hedge fund manager, the S&P 500 stands up a lousy 0.6 percent on the year. That could happen again. But I would put greater odds on a real reckoning. The long series of attempts to save the Eurozone in the final months of 2011 staved off collapse, but they fixed nothing. The enormous overhang of leveraged debt and the impossibility of restoring economic growth in the West are still with us, and every month that passes without an honest strategy to bring obligations in line with hard asset values only increases the threat. Faith in the markets, the dollar, and the euro has all but evaporated, and our economies now hang by a string dangling from the hand of Ben Bernanke. If that string doesn’t break in 2012, it will in 2013, or 2014 at the latest. The key question is how long the world’s central bankers can skate on the thin rim of the deflationary vortex.

Should the global financial regime fail, there will be blood in the markets. Bank runs are not out of the question. Commodity and equity prices could fall to the tune of 40 percent or more, but without destroying enough demand in Asia to restore a comfortable cushion of supply in oil and agricultural commodities. Here, it is useful to reflect on 2008. From 2005 on, the data suggested that 2012 would be the turning point when oil supply began its long, inevitable, terminal decline. But the crash of 2008 bought us a few more years of adequate oil supply at a moderately uncomfortable price, and pushed that point off, at least theoretically, to around 2014. If there is a similar crash in 2012, the turning point could be delayed another year or two, but only if supply from all of the highly unstable sources mentioned above remains firm. I would put 50-50 odds that it does not, in which case prices will remain uncomfortably high even as deflation takes a firmer grip on Western economies. The world will be hard-pressed to increase liquid fuel supply from current levels.

Certain uncertainty

The one thing I can say with certainty about 2012 is that it will be fraught with uncertainty. 2011 could look tame by comparison.

More natural disasters are almost certainly on the menu, which will disrupt supply chains and exact a painful toll of blood and treasure the world over.

Regional skirmishes over resources, particularly in developing oil-rich areas like the Caspian and Africa, are likely.

Authoritarian governments, along with their corporate sponsors, will continue to be challenged by the people, and will resort to heavy-handed crackdowns in response. The Arab Spring and the Occupy movement are merely the beginning of popular revolts that will ultimately transform the political and economic order of the world. Unrest in previously pacific areas should be expected.

Intelligence agencies will find it difficult to keep up with multiplying threats. Attacks by the hacker group Anonymous on powerful vested interests, like the Christmas weekend attack on the US-based security think-tank Stratfor, will become more commonplace and focused on high-value targets like government and military organizations. The potential disruptions to business as usual are hard to overestimate. Banks, public services, utility grid operators, and communications systems could suffer extended outages. Electronic systems of exchange could be compromised. Faith in our large, complex systems will wane.

In the face of all this uncertainty, then, what is one to do?

The answer is simple: Do what you can.

Minimize your expenses, and pay down debt as rapidly as possible.

Grow some of your own food, whether you have a big backyard or just a little balcony with room for a couple of small pots. Millions of people have begun doing so since the crash of 2008, and they have found it a universally rewarding and fun experience. It helps to ground one in reality, and brings a little peace of mind. Before you know it, you’ll be expanding your garden and maybe keeping a few chickens.

Reduce your consumption of fossil fuels any way you can, by focusing on efficiency. Then (and only then), if you can, think about installing some solar hot water, solar PV, and battery backup on your house or business. I expect the distributed solar market to be a rare and surprising bright spot in 2012.

Keep a little “rainy day” cash on hand. To really hedge your exposure to financial collapse, physical gold and silver bars and coins are your best insurance.

Renew your relationships with friends, family and neighbors. Nothing is worse than feeling alone when the world is going crazy around you, and they will help you keep your head on straight.

Most importantly: Try to keep your mind in the present. Don’t let the uncertain future frighten you into immobility, and don’t let the past keep you from doing the best you can today. It’s surprisingly hard to do, but it gets easier with practice. The Buddhist approach is to simply be mindful of what you’re doing, seeing, hearing, and feeling right now, be it walking down the street or cleaning the cat box. Or, in the Biblical verse of Matthew 6:34, “So do not worry about tomorrow; for tomorrow will care for itself. Each day has enough trouble of its own.”

I wish all of us luck, wisdom, fortitude, and peace of mind in what will undoubtedly be a very challenging year. We will soldier on, somehow.

Photo: marcobellucci/Flickr