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No October Surprise

"When we first got here, we tried making friends. We did everything we could to make friends with these people. Then I started evacuating my friends [who had been killed or injured], and it wasn't cool anymore." – US Marine Jeremy Heidrick in Iraq, St. Louis Post-Dispatch, 19 April 2004

Worried about $40 per barrel oil? You needn't be, if Bob Woodward is anyone to go by. According to Woodward, Saudi Arabia's ambassador to the United States, Prince Bandar bin Sultan, promised President Bush the Saudis would cut oil prices before November to ensure the U.S. economy is strong on Election Day. In an interview with CBS's 60 Minutes about his new book Plan of Attack on the Bush administration's preparations for the Iraq war, Woodward, a senior editor at the Washington Post, said Prince Bandar pledged that the Saudis would try to fine-tune oil prices to prime the U.S. economy for the election -- a move they understood would favor Bush's reelection.

It sounds wonderful, but if such a pledge was ever given, Saudi actions in the past year suggest that it has been revoked, largely in response to the growing geopolitical morass that is developing in the Middle East. In the aftermath of Gulf War II, it was felt that mobilization against Iraq would give the United States a renewed opportunity to expand its power and influence in the region -- this time potentially to use its new Persian Gulf bases to establish even more bases in the ancient territories between the Tigris and Euphrates rivers in Iraq, while remaking a hitherto backward region into a bastion of Anglo-American liberal-democracy. More importantly, many of the neo-cons who now dominate Administration thinking felt that the oil fields seized as a by-product of this invasion would give the United States a de facto seat in OPEC, and control over a huge cash-generating asset required to fund its massive domestic and overseas debt build-up. At the same time, it was also hoped that President Bush would use his expanded leverage to press for a comprehensive settlement of the Palestinian-Israeli conflict.

All of these blithe assumptions look questionable today, to say the least -- none more so than the assumptions about oil.

After the end of the Iraq invasion, the oil price fell sharply to $26 (WTI), although little of this can be ascribed to the Saudis, who have been producing at roughly the same capacity of between 8.5 and 9.4mmbd of crude oil, natural gas, and gas liquids for the past ten years, according to figures collated by independent oil analysts, Groppe, Long & Littell (GLL). These price forecasts, made by a number of prominent Wall Street banks such as Citicorp, were based on two assumptions: precautionary inventories built prior to the Middle East hostilities would be liquidated and, under the U.S. occupation, Iraqi oil would flow soon and copiously. In turn, that Iraqi oil would at least pay for the occupation and reconstruction of Iraq -- so believed neoconservative planners in Washington and in the new Coalition Provisional Authority set up by the Bush administration in Baghdad.

Since the U.S. occupation of Iraq began, the pipelines north of Haditha have been the targets of repeated sabotage. The result, according to GLL, is a shortage of natural gas and the inability to use all of the capacity of Iraq's refineries. Consequently, the country is still producing well below its current estimated capacity of 2.5mmbd of crude oil production. Equally problematic from the Americans' perspective is the increasingly unaccommodating policy stance of the Saudis, who had hitherto been relied upon to offset looming oil shortages. As it now stands, the Israel-Palestine conflict has no direct impact on Middle Eastern oil supplies. However, it has led to a movement of solidarity among Middle Eastern states against the Bush administration's perceived one-sided support of Israel and in addition has led the Saudis, fearing their "special relationship" with America to be under threat, to play the oil card in a manner highly inimical to American economic interests.

It is not as if the Bush Administration wasn't warned: Before his visit to Bush's ranch near Crawford, Texas, Crown Prince Abdullah (through his interpreter) told the press that allowing the Israeli-Palestinian conflict "to spiral out of control will have grave consequences for the United States and its interests." On June 10th last year, the Saudi oil minister, sent letters to the companies negotiating contracts for participation in the natural gas industry of the Kingdom. Subsequent to those letters, the following has occurred:

*July, 2003 – The Saudi government announces gas agreements with Shell (Anglo-Dutch) and Total (French)

*August – State visit to Moscow by Crown Prince ‘Abd' Allah-al-Saud

*September – OPEC ministers adopt Saudi Arabia's proposals to reduce production quotas, despite of expectations in advance of the meeting that the status quo would be maintained.

*January, 2004 – Saudi Arabia announces gas agreements with Lukoil (Russian), Sinopec (Chinese), Agip (Italian), and Repsol (Spanish)

*February – OPEC Ministers adopt another Saudi proposal to reduce production quotas.

Note the complete exclusion of U.S. energy companies in all prominent new Saudi energy ventures; this is hardly consistent with an ostensible pledge to flood the market with oil around October to guarantee the election of a President viewed to be fundamentally hostile to Islamic interests by the vast majority of OPEC nations. It is equally salient that the officially stated OPEC price range of $22-$28 per barrel has largely been ignored by virtually all OPEC members (judging from the extent to which they are producing above agreed quota numbers) – not only because higher prices can be sustained in spite of this widespread "cheating" on quotas, but also because of growing opposition among its members to American policies in the Middle East.

The new, largely unarticulated high oil price strategy should be viewed in the context of Saudi promises to invest billions in the development of the Russian energy industry, and suggestions of an emerging Russo-Saudi oil alliance. Last December, the Russian government announced that its policy for production is to stay under 9.0mmbd for the next five years. Five years is also the term of the oil and gas co-operation agreement signed with Saudi Arabia on September 2, 2003, at the end of the state visit by Crown Prince Abdullah.

The significance of this alliance for the oil market lies in the fact that, in 1998, the value of Russian oil exports was a mere $16bn. In 2003, their value was over $63bn -- second only to the $80bn worth of exports by Saudi Arabia. This increasing cohesion of Russian and Saudi energy policies is occurring against a backdrop in which the oil supply/demand balance is tighter than usual and long-term depletion rates are much higher than is generally recognized. Although Saudi Aramco (the state oil company) has historically done what is required to offset declines in existing oil fields and maintain an estimated capacity of approximately 10mmbd through new projects, the higher production required to generate a sharp fall in oil prices cannot be achieved without more personnel and investment, according to both GLL and Houston-based oil analyst Matt Simmons of Simmons & Co, who has recently undertaken an extensive study of the Saudi oil fields.

In fact, given that most OPEC members are already producing close to full capacity (and well in excess of official quota figures), without significant new discoveries in Russia, the effects of more rapid depletion dynamics will manifest themselves much earlier than currently envisaged by the market. From a peak of 11.06mmbd in 1988, Russia's actual crude oil production in 2003 had fallen to a little less than 8.0mmbd, according to GLL. Much of the new technology introduced to develop Russia's energy fields will only accelerate rates of depletion in existing fields, leaving remote areas of Siberia as the key variable in determining whether the Putin administration can achieve its publicly stated goal of 9.0mmbd production, let alone get anywhere near the peaks sustained during the late 1980s.

Given that the Saudis and the Russians are two of the world's largest oil suppliers, the effects of their de facto alliance cannot be overestimated. In early 2003, Saudi Arabia facilitated the invasion of Iraq by temporarily increasing oil production, but all actions subsequent to a June 10th Saudi decision to end negotiations with U.S. companies on the development of the Saudi natural gas fields have been consistent with a broader Saudi reassessment of its respective relations with both the U.S. and Russia.

In 2002, the OPEC oil ministers met 4 times. In 2003, they met 7 times. Thus far in 2004, they have already met twice. The significance of the increased frequency of these meetings over the past 18 months (at least in contrast to the comparative paucity of meetings from the early 1990s through 2002) is that it has allowed OPEC member states to better minimize the risks of overproduction relative to quota allowances. The monitoring of overproduction can be more accurately calibrated with more frequent meetings, note Groppe, Long, & Littell. In fact, GLL argues that OPEC has in effect moved closer to the old model of the Texas Railroad Commission, which still sets monthly allowances for production in Texas. As GLL notes: "The genius of the monthly meetings of the Railroad Commission is that the commissioners did not have to depend on their ability to forecast accurately. Any mistakes made – and some were – could be corrected at the next meeting."

The goal here appears clear: limit overproduction and keep oil prices high, not flood the market with cheap oil. And with the Saudis clearly not playing ball on oil, one can only surmise that their hitherto almost reflexive move to recycle petrodollar surpluses back into the dollar has likely dissipated as well, removing an important marginal bid in the bond market, at a time when inflationary pressures are intensifying and 10-year bond yields have headed north of 5%. The broader economic and geopolitical implications are enormous: the House of Saud, which has cultivated a special relationship with successive U.S. administrations since the days of FDR, seems to have effectively decided that politically and economically distancing itself from at least the present American government provides a much better means of ensuring its long-term survival.

All of this implies an increasingly precarious backdrop for U.S. financial assets and the dollar, the rallies in which do not fully reflect today's deteriorating geopolitical and economic variables. Consumers have reached debt saturation with short-term rates at 1%. What happens as rates rise and the oil price explodes? A further price spike in energy could well exacerbate a growing inflationary psychology now predominant in the credit markets, which in turn could undermine the Fed's recent efforts to "talk down" yields on long-term interest rates.

An oil shock potentially endangering U.S. national security and economic interests is the last thing a debt-saturated America, embarking on expensive overseas ventures, needs right now. Yet that appears to be where we are headed today, the consequences of which are not yet fully reflected in the markets.

Marshall Auerback is an international portfolio strategist for David W. Tice & Associates, a US money management firm with approximately $1 billion in assets. His weekly "International Perspective" can be seen at PrudentBear.com

Copyright C2004 Marshall Auerback

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