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The Oil Price War

By George Venturini

05 April, 2015
Countercurrents.org

In a stunning but little-known speech delivered in 2007, Gen. Wesley K. Clark claimed that America underwent a ‘policy coup' at the time of the 9/11 attacks. He had documented the progress of that coup in a book titled Winning modern wars, Iraq, terrorism and the American Empire that Gen. Clark had published in 2003. He was not just the usual retired general. He had been Supreme Allied Commander, Europe, from 1997 to 2000.  In a 3 October 2007 video, he revealed that, right after 9/11, he was privy to information contained in a classified memo: ‘US plans to attack and remove governments in seven countries over five years: Iraq, Syria, Lebanon, Libya, Somalia, Sudan and Iran'. At the Pentagon he was told: “We learned that we can use our military without being challenged …. We've got about five years to clean up the Soviet client regimes before another superpower comes along and challenges us.” “This was a policy coup…these people took control of policy in the United States.   …”

In an interview on 24 September 2012 General Clark linked three topics: oil, war and activism. He explicitly laid out the central role of oil in American military strategy, and advocated for increased use of clean energy alternatives. He also said that the only way to change policy on energy and the military is for a mass public movement to stand up to the oil industry, the richest and most powerful in history. He said that young people have the most to gain, and will have to take the lead.

Here is a transcript of what Gen. Clark said:

“… So energy is about generating electricity. There you can move pretty quickly into solar and wind. Not only are the costs coming down through better engineering and better scientific development, but also battery technology is improving so you can store it and feed it into the power grid at the time you need it, not just when it's generated.

But on the other hand, there is transportation fuel. And that's mostly oil. And that's mostly imported. And that's what people fight wars about, mostly they don't fight war about coal, they fight about oil.

In the summer of 1973 in Washington, I wrote three reports about the energy crisis for the Pentagon, one of which looked at the impact of being an oil-importing nation on the United Sates. And it was pretty clear even then that this would distort America's foreign policy, spread lots of money abroad, and might ultimately require us to use U.S. troops to secure access to these energy supplies abroad.

Of course that's exactly what happened. This led then to the creation of al-Qaeda, 9/11, our invasion of Afghanistan, the Bush administration decision to invade Iraq. It's led to expenditures of a couple of trillion dollars and more, much more to follow. And we're not done yet.”

To the question: “What would you estimate we're spending annually on keeping the oil pipeline open ?” General Clark replied:

“Well, it's 300 billion dollars of US foreign exchange to buy the oil, another 600 billion dollars for the defense budget. Not all of that is directed toward energy but you could say that 150 billion dollars a year we're spending on the wars is certainly about oil, directly or indirectly.

And you could probably say half of the rest of the defense budget is one way or another connected to stationing troops abroad, trying to protect access to oil, exercises, procurement of equipment. And then you could look at the bill for the Veterans Administration. So this comes out to be half a trillion dollars or more a year, is going to this. It's been a tragic failure of policy and a failure of US leadership.

How can we replace these barrels of oil with other means of energy? The alternatives are there now, and bio fuels, compressed natural gas, electric automobiles increasingly, liquefied natural gas, coal to liquids. There's lots of different ways to make liquid fuel.

So I think that it's a matter of a struggle for political organizations. I think it does take the kind of movement that you've talked about. I think you have to mobilize young people. I think you have to, not just young people, but young people in particular. After all, they have the most to gain from the future – and the most to lose. And they need to speak up on behalf of these issues.

Because they're going against some very, very powerful forces. Forces of big oil are the most powerful economic forces in the world. If you look at the entire wealth of mankind, the value of oil reserves in the ground is like 170 trillion dollars. It's the most valuable commodity as currently priced in the world. You're going against people who control those reserves. So this can only be done through a mass movement that overturns the established structure of energy markets. It can't be done in a smooth transition.”

The ‘thirst for oil' is often put forward as a near self-evident explanation behind military interventions.

Oil prices fell more than 50 per cent between June 2014 and March 2015, possibly marking the end of the commodity price super cycle which began in the early 2000s. The decline has been quite large, but not unprecedented. The latest episode has some significant parallels with the price collapse in 1985-1986, which also followed a period of strong supply of unconventional oil and the eventual decision by the Organisation of the Petroleum Exporting Countries, O.P.E.C. to forgo price targeting.

Energy prices started to move downward when Saudi oil began to flood energy markets. Variations of two main views about this emerged. One view explained things purely on the basis of business interests whereas the other view saw the drop in oil prices geopolitically.

Some analysts viewed the Saudi move as a means of forcing out competitors in a saturated market with falling demands which has been caused by economic stagnation. Within this group of analysts, there were also those who viewed this as an attack on the growing shale industry in the United States. According to this view, Saudi Arabia is trying to push U.S. shale production out from the market by making extraction unprofitable and ultimately expanding its share of the market at the expense of U.S. producers.  The decline in oil prices will hurt production in areas not controlled by O.P.E.C. and this may be a means of preventing the oil market from transforming from a ‘seller's marker' into a ‘buyer's market'.  

Brent crude oil prices fell to US$ 45 a barrel at the end of January 2015   -    crude oil West Texas Intermediate closed at $44.35 by the end of trading on 13 March  2015   -     from as high as US$ 115 in June 2014, marking the end of a four-year period of fluctuations in the range of US$ 93-$118, for the first time since 2009. Prices have recently rebounded to levels close to US$ 60 and most forecasts point to prices oscillating between US$ 50 and US$ 80 a barrel for through 2016.

The causes of this fall are many: from greater competition in global oil markets, other geopolitical factors, O.P.E.C.'s production stance, oversupply, weak demand and the strong dollar.

The falling price of oil could lead to economic growth; it will also lead to destabilising political effects in countries with oil-dependent economies.

The death of Saudi Arabia's King Abdullah bin Abdulaziz on 23 January 2015 adds a measure of uncertainty to O.P.E.C.'s oil policies, which boosted prices in global oil markets after the news early that day, though analysts say the kingdom is unlikely to change its strategy and reduce production. That is despite a global glut of crude which is fuelling new rivalry between O.P.E.C. and Russia for China's market  -   as well as among O.P.E.C. nations themselves.

O.P.E.C.‘s officials thought that maintaining high production levels would protect market share in crucial importing nations.

Reports indicated that the rise in prices was temporary and Saudi Arabian oil policies will not change before the O.P.E.C. meeting in June 2015.

The announcement of the Saudi royal death was followed by a 2.6 per cent increase in the price of Brent oil, the benchmark for global oil prices, while the U.S. marker, the West Texas Intermediate, also went up by 3.1 per cent.

The new king, Salman bin Abdulaziz Al-Saud,  who is the half-brother of the deceased king Abdullah, has announced on national television that he will maintain his predecessor's policies. Oil Minister Ali Al-Naimi will also remain in his post.

Saudi Arabia, O.P.E.C.'s largest oil producer, has maintained a policy of high production and refused recommendations by countries such as Iran and Venezuela to reduce production in an attempt to control oil prices.

Saudi Arabia's powerful oil minister made a very strange comment on 22 December. He told the Middle East Economic Survey that it was “not in the interest of opec producers to cut their production, whatever the price is.” [Emphasis added]    “Whether it goes down to US$ 20 a barrel, US$ 40, US$ 50, US$ 60, it is irrelevant.” he added.

This is the third-sharpest decline in history, yet the Saudis seem to want it to go even lower. This is strange because o.p.e.c. cartel was founded to do just the opposite: to keep oil prices high by limiting supply.

According to a new paper issued by the World Bank, titled The Great Plunge in Oil Prices: Causes, Consequences, and Policy Responses, rapid expansion of oil supply from unconventional sources and weak global demand are driving the recent plunge in oil prices.   These underlying forces are buoyed by a strengthening U.S. dollar and the fact that oil production in the Middle East has not been severely disrupted by the ongoing conflict.

As the paper documents, “following four years of relative stability at around US$ 105 per barrel, oil prices have declined sharply since June 2014 and are expected to remain low for a considerable period of time. The drop in prices likely marks the end of the commodity supercycle that began in the early 2000s. Since the past episodes of such sharp declines coincided with substantial fluctuations in activity and inflation, the causes and consequences of and policy responses to the recent plunge in oil prices have led to intensive debates.” The paper addresses four questions at the centre of these debates, with particular emphasis on emerging market and developing economies: 1) How does the recent decline in oil prices compare with previous episodes?, 2)  What are the causes of the sharp drop and what is the outlook for oil prices?, 3)  What are the economic and financial consequences? and 4)  What are the main policy implications?

The paper adds: “The sharp fall in oil prices since June 2014 is a significant but not unprecedented event. Over the past three decades, five other episodes of oil price declines of 30 percent or more in a seven-month period occurred, coinciding with major changes in the global economy and oil markets.  ... The latest episode has some significant parallels with the price collapse in 1985-86, which followed a period of strong expansion of supply from non-OPEC countries and the eventual decision by OPEC to forgo price targeting and increase production.”

* * *

The history of oil prices over the last century shows that the recent fall in oil prices is the product primarily of two factors: 1) international supply and demand for oil, which remains the lifeblood of the modern industrial economy, and 2) the value of the dollar, the currency in which oil is priced.

Since dollars buy oil, if the value of the dollar is high against other currencies, then fewer dollars buy more oil even if the cost of oil priced in other currencies remains unchanged. Conversely, if the dollar's value depreciates, then more dollars are needed to buy the same amount of oil. Oil price fluctuations therefore may not always reflect its cost when priced in other currencies.

However, since oil is paid for in dollars, it has traditionally been an inflation hedge for international investors holding large amounts of dollars, especially when the currency is depreciating.   This tends to make the price of oil rise even more in periods of dollar weakness.  When the dollar is weak, the oil price tends to be high.

The other factor which determines price is the balance of supply and demand. When there is  -  as is the case today  -   a situation of over-supply, the oil price tends to be low. When there is excess demand, the oil price tends to be high.

A brief review of recent history shows that it is the interaction between these two  factors, namely the balance of supply and demand, and the prevailing position of the dollar, which determines the oil price.

Oil, often referred to as ‘black gold', was recognised as a strategic commodity because more than 100 years ago, in 1911, then Britain's First Lord of the Admiralty, Winston Churchill made a remarkable decision to shift from coal to oil as a source of energy.   That decision was seen instrumental in securing victory for the Allies as well as securing the oil politico-economic affinity.

It was the Arab-Israeli war of 1973 and its fallout by the Arab oil embargo, then the Iranian revolution which consolidated the relationship between oil and politics. Even the 1986 oil price war was given a political dimension and was seen as playing a considerable role in the collapse of the Soviet Union three years later.
However, the commonly shared central and crucial point to remember is that in both cases now and back in 1986 the drop in oil prices is and was in fact a reaction to market realities and not a deliberate action to achieve certain political ends.  It was a different market then in 1986, when O.P.E.C. was adopting a strategy of defending an official bench market price.

The dollar's role as the world's reserve currency was first established in 1944 with the Bretton Woods Agreement. The U.S. was able to assume this role by virtue of it then having the largest gold reserves in the world.    The dollar was pegged at US$ 35 an ounce    -    and freely exchangeable into gold at that rate.

In the first decades after the second world war the dollar  -   the value of which at that time was fixed to gold   -   was very strong. There was also an abundant supply of oil caused by the recent opening up of oil fields in the Arabian Gulf and in Venezuela. As a result, oil prices during this period were low and stable.

This phase of low oil prices had catalysed the rapid growth of western economies during this period. Those who believe it was low oil prices in the 1980s which brought about the Soviet Union's collapse should remember that it was during this same period of low oil prices that the Soviet economy achieved its longest period of rapid, sustained growth.

Over time, rapid economic growth in ‘the West', caused in part by low oil prices, increasingly led demand to outstrip supply. Concurrently, heavy spending in the U.S. to finance the space programme, a massive build up of the U.S.'s nuclear forces, President Johnson's ‘Great Society' programme and the Vietnam war, combined with a loose monetary policy by the U.S. Federal Reserve, had caused the internationally traded value of the dollar to depreciate. 

By the late 1960s, European countries began to insist that the U.S. settle payments in gold and in 1971 the U.S. government was forced to sever the dollar's link to gold and allow the currency to float freely.  By 1971 convertibility into gold was no longer viable as America's gold resources drained away.

The result was that oil prices suddenly quadrupled in dollar terms, though not against the gold price, against which they simply recovered to their previous level. The event which exacerbated the rise in the dollar price of oil, but which did not cause it, was the oil embargo imposed briefly by the Arab states during the 1973 Arab-Israeli war.

The dollar became a pure currency   -   decoupled from any physical store of value, until the petrodollar agreement was concluded by President Nixon in 1973.   The essence of the deal was that the U.S. would agree to military sales and defence of Saudi Arabia in return for all oil trade being denominated in U.S. dollars.   The dollar then became the only medium in which energy exchange could be transacted.

This underpinned its reserve currency status through the need for foreign governments to hold dollars; recirculated the dollar costs of oil back into the U.S. financial system and   -   crucially    -   made the dollar effectively convertible into barrels of oil.

The dollar was moved from a gold standard onto a crude oil standard.

U.S. interest rates were then managed so that oil exporters    -  who formerly looked to gold as the basis of their reserves   -   would be indifferent to whether they stored their currency reserves, earned from oil exports, in U.S. treasuries, or in gold. The value was equivalent.

In the 1980s conditions brought to an oversupply of oil at the very same time that the U.S. Federal Reserve, under its chairman, Paul Volcker, suddenly tightened monetary policy in order to choke off domestic inflation  -  the so-called ‘Volcker Shock'  -   causing the dollar to strengthen. The combination of oil oversupply and a strengthening dollar caused oil prices in the mid-1980s to collapse.

It is this mid-1980s oil price collapse that is popularly believed to have been the result of a plot between the Saudis and the Reagan administration to bring down the Soviet Union.

 Oil prices, nevertheless, experienced a second collapse in 1997 when  chairman Alan Greenspan briefly reversed his policy, tightening monetary policy by raising interest rates, causing the value of the dollar to rise. The rise in the dollar in conditions of global oversupply of oil caused another collapse in the oil price in 1997. This in turn led to the Asian financial crisis and the collapse of the rouble and Russia's default the following year.

Energy producers began to accumulate real assets   -  such as real estate, and returned to purchasing physical gold in lieu of U.S. treasuries.

The petrodollar system, which had allowed the U.S. dollar to supplant gold as the support for the oil trade from 1973-2002, was broken.

The greedy, testosterone-fuelled, male-dominated grand larceny exercise which became euphemistically called ‘the global financial crisis of 2008' briefly caused the dollar to strengthen  -  as it came to be seen as a safe haven  -   and demand for oil to fall as economic activity around the world diminished. The result was another collapse in oil prices. The reason they recovered so quickly at the time was because the response by the U.S. Federal Reserve to the 2008 financial collapse was to loosen monetary policy even more through a combination of near zero interest rates and the so-called ‘quantitative easing programme'. 

Summing up: the history of inflation-adjusted oil prices since 1974, when O.P.E.C. first emerged, reveals two distinct pricing regimes. From 1974 to 1985, the US benchmark oil price fluctuated between US$ 50 and US$ 120 in today's money. From 1986 to 2004, it ranged from US$ 20 to US$ 50   -  apart from two brief aberrations after the 1990 invasion of Kuwait and the 1998 Russian devaluation. Finally, from 2005 until 2014, oil again traded in the 1974-1985 range of roughly US$ 50 to US$ 120   -   apart from two very brief spikes during the 2008-2009 financial crisis.

Finally, in 2014 the long established re-circulation of petrodollars back into the U.S. financial system came to an end.

http://russia-insider.com/sites/insider/files/styles/s400/public/field/image/kaletsky7chart01.png?itok=-mfC9rn8

Historically, the Arab petro-sheikhdoms have manipulated energy prices in coordination with the U.S. Moreover, even if the American shale industry collapses or freezes it operations, this does not mean that in the future, when the world's finite energy supplies are lower    -   and costs are higher,   exports and ‘fracking' would not be resumed.

Saudi Arabia was reinvesting capital back into the U.S. economy during the 1968 Arab Oil Embargo. On the other hand, the United States have used the rise in oil prices to strengthen its economic influence over the Western European and Japanese economies through the petro-dollar.  In this regard, the rise in energy prices was also used to weaken and swallow other economies, include in the ‘Eastern Bloc'. 

The world is still committed to a hydrocarbon-based energy. Russia is one of the world's largest producers of energy. Russia has recently announced that in the future it will no longer trade energy in U.S. dollars, but in roubles and currencies of the trading partners. In fact, this rule will apply to all trading. Russia and China are detaching their economies from that of the western financial system. To confirm this decision, in July 2014 Russia's Gazprom concluded a 400 billion gas deal with China, and in November 2014 they signed an additional slightly smaller contract  - all to be denominated in roubles and renminbi, the official currency of China.

 The remaining BRICS   -   Brazil, India and South Africa   -   plus the members of the Shanghai Cooperation Organization, S.C.O.  -   China, Russia, Kazakhstan, Kirgizstan, Tajikistan, Uzbekistan and considered for membership since September 2014 such as India, Afghanistan, Iran, Mongolia and Pakistan, with Turkey also waiting in the wings   -   will also trade in their local currencies, detached from the dollar-based scheme. A host of other nations increasingly weary of the decay of the western financial system into which they are locked are just waiting for a new monetary scheme to emerge. So far their governments may have been afraid of the United States' reaction   -   but gradually they gaining confidence. They do not want to be sucked again into a black hole if there is another crisis of the 2008 kind.

* * *

One can hardly discuss oil prices without considering the world's premier oil cartel: the Organisation of the Petroleum Exporting Countries  -  O.P.E.C.

 

OPEC nations

The Organisation was founded in Baghdad, Iraq, with the signing of an agreement in September 1960 by five countries, namely Islamic Republic of Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. They were to become the Founder Members of the Organisation. It is headquartered in Vienna, Austria.   At that time the international oil market was largely dominated by a group of multinational companies known as the ‘seven sisters'. The formation of O.P.E.C. represented a collective act of sovereignty by oil exporting nations, and marked a turning point in state control over natural resources. In the 1960s O.P.E.C. ensured that oil companies could not unilaterally cut prices.

These countries were later joined by Qatar in 1961, Indonesia in 1962, Libya in 1962, the United Arab Emirates in 1967, Algeria in 1969, Nigeria in 1971, Ecuador in 1973, Gabon in 1975  and Angola  in 2007.  From December 1992 until October 2007, Ecuador suspended its membership. Gabon terminated its membership in 1995. Indonesia suspended its membership effective January 2009.

Currently, the Organisation has a total of 12 Member Countries: Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela.

The O.P.E.C. Statute distinguishes between the Founder Members and Full Members - those countries whose applications for membership have been accepted by the Conference.

The Statute stipulates that “any country with a substantial net export of crude petroleum, which has fundamentally similar interests to those of Member Countries, may become a Full Member of the Organization, if accepted by a majority of three-fourths of Full Members, including the concurring votes of all Founder Members.”   The Statute further provides for Associate Members which are those countries which do not qualify for full membership, but are nevertheless admitted under such special conditions as may be prescribed by the Conference.

The Organisation's mandate is to “coordinate and unify the petroleum policies” of its members and to “ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital for those investing in the petroleum industry.”

According to the United States Energy Information Administration, O.P.E.C. crude oil production is an important factor affecting global oil prices. O.P.E.C. sets production targets for its member nations and generally, when O.P.E.C. production targets are reduced, oil prices increase. Projections of changes in Saudi production result in changes in the price of benchmark crude oils.

Saudi Arabia is the world's largest producer of oil and is responsible for exporting a third of O.P.E.C.'s, approximately 10 million barrels per day. The nation's leaders opposed a plan proposed by Russia, Iran and other O.P.E.C. oil exporters in November 2014 to slow down production and increase sale prices over fears that deceased exports would allow other nations to seize a larger portion of the market share.

For several of these member nations, oil is a matter of life and death. The International Monetary Fund in October 2014 analysed the oil prices various governments' need to balance their budgets. The nations on the Arabian Peninsula   -    Saudi Arabia, Kuwait, the United Arab Emirates and Qatar  -   can survive with US$ 70 per barrel oil. These nations also tend to be the ones with the largest financial reserves. According to one estimate, Saudi Arabia could survive for two years at these prices with minor difficulty. These low-cost o.p.e.c. producers may even benefit in the longer term from lower oil prices.

Some analysts, including those quoted by friendly American newspapers, have speculated that the Saudis desire to drive prices lower was specifically targeted at U.S. ‘fracking' companies which are responsible for almost the entire increase in global oil production over the past five years. On 3 November 2014 the Wall Street Journal quoted Saudi sources saying they would sell oil to America for less than their Asian customers. So it is possible that U.S. production was a target of the Saudis, but it is more likely the sheiks had other targets in their sights.

Some of o.p.e.c. nations are the big losers. While Saudi Arabia, Kuwait, the United Arab Emirates and Qatar can live with relatively lower oil prices for a while, this is not the case for Algeria, Angola, Iran, Iraq, Nigeria and Venezuela, because in those countries strong demographic pressure is feeding their energy and budgetary requirements. The price of crude is paramount for their economies because they have failed to diversify.

Towards the end of December 2014 Saudi Arabia's position was that it will not cut oil production even if the price drops to US$ 20 a barrel and that it is unfair to expect the cartel to reduce output if non-members do not.

“Whether it goes down to US$ 20 a barrel, US$ 40, US$ 50, US$ 60, it is irrelevant.” Saudi Oil Minister Ali al-Naimi said in an interview with the Middle East Economic Survey.  In unusually detailed comments, al-Naimi defended the November decision by O.P.E.C. to maintain a production ceiling of 30 million barrels per day.   The decision sent global crude prices tumbling, worsening a price drop which has seen them fall by around 50 per cent since June.  Slower demand growth and a stronger dollar have also contributed to the slump.

Saudi Arabia has traditionally acted to balance demand and supply in the global oil market because it is the only country with substantial spare production capacity, according to the International Monetary Fund.  The increasingly competitive global oil market has seen daily United States output rise by more than 40 per cent since 2006, but at a production cost which can be three or four times that of extracting Middle Eastern oil.

“Is it reasonable for a highly efficient producer to reduce output, while the producer of poor efficiency continues to produce ?” al-Naimi asked during the interview conducted with the Review.  “If I reduce, what happens to my market share ? The price will go up and the Russians, the Brazilians, U.S. shale oil producers will take my share.”

Al-Naimi added that it is “unfair” for the cartel to reduce output because it is not pumping most of the world's oil.  “ Saudi Arabia is producing almost 10 million barrels of crude a day.  … We produce less than 40 per cent of global output. We are the most efficient producer. It is unbelievable after the analysis we carried out for us to cut.” he said.

Repeating comments he had made elsewhere, al-Naimi told the Review that oil prices will, however, improve.

“The timing is difficult to know.” he said, but international oil companies have reduced their future capital expenditures, “which means there is no exploration.”   That, in turn, signals they will not have additional production, he added.

The minister said hat O.P.E.C. was not surprised by the extent of the price drop.  “No, we knew the price would go down because there are investors and speculators whose job it is to push it up or down to make money.” he told the Review.

Al-Naimi said that with their comparatively low production costs of US$ 4-US$ 5 a barrel, Gulf nations and particularly Saudi Arabia “have the ability to hold out.”  Other nations would be “harmed greatly before we feel any pain.” he added.

Russia, the estimated production of which topped 10 million barrels a day in 2014, has seen its rouble currency collapse since the November's O.P.E.C. meeting, partly from the slumping global prices which hit Russian exports.

In and around O.P.E.C. there have been winners and losers. 

China, India and South Africa have benefited from lower oil prices.

According to estimates in the Global Economic Prospects released by the World Bank in January 2015, a 10 per cent decrease in oil prices is expected to lift growth in oil-importing economies by something in the range of 0.1-0.5 percentage points, depending on the share of oil imports in Gross Domestic Product. Positive fiscal and current-account impacts are also expected.

In China, the World Bank estimates an activity-boosting effect of lower oil prices in the range of 0.1-0.2 per cent, given that oil comprises only 18 per cent of energy consumption. A deflationary impact is also a possibility, although it will be limited as energy and transportation correspond to less than 20 per cent of the Consumer Price Index. Fuel subsidies amount to only 0.1 per cent of G.D.P., so fiscal impacts will not be significant. On the other hand, as China remains the second-largest world importer, lower oil prices throughout 2015 will likely raise its current account surplus by 0.4-0.7 percentage points of G.D.P.

India has an oil import bill of 7.5 per cent of G.D.P. and has derived high terms of trade gains from the oil price evolution. Furthermore, its challenges with fiscal deficits and high inflation have been made easier. The government has already taken the opportunity to phase out diesel subsidies and hike taxes on oil derivatives. Falling oil prices have also helped to bring inflation down to less than 4.5 per cent a year last December, opening space for some monetary policy loosening ahead.

South Africa is also a net importer of oil and a beneficiary from lower prices, including by corresponding effects on inflation and the import bill. As far as current-account deficits and G.D.P. are concerned, recent oil price developments have come as a relief after the previous decline of prices of metals and minerals, which comprise a substantial part of the country's exports and G.D.P.

Brazil has a small deficit on its oil foreign trade  -  as compared to the preceding countries  -  and that qualifies it for potential benefits of declining prices both on its current-account deficit and as a facilitator for an undergoing domestic price realignment of oil derivatives. On the other hand, the new international price regime and levels have come at a moment in which strong bets on future oil-related investments had been made in previous years, towards an expected crossing of the threshold to the group of net-exporting countries.

Speaking at the Davos Economic Forum in Switzerland on 20 January 2015, O.P.E.C.'s secretary-general, Adballa Salem El Badri did not rule out a drop in oil prices below US$ 40 a barrel.  “The oil market is oversupplied, while the demand is declining amidst weak economic growth forecasts.” he said.  He added that the crude oil prices might fall “to US$ 40 a barrel and even below that level.”  The problem is that the plunge in oil prices was too sharp, and fundamental market indicators do not correspond to a 40-50 per cent drop, Adballa Salem El Badri said.

Algeria, Angola, Iraq, Libya, Nigeria and Venezuela are all considered Iran's o.p.e.c. allies  -   and bitter enemies of the Saudis.

These nations all need US$ 100 per barrel oil or higher to balance their budgets. And of these nations, it is thought that Iran is the most vulnerable to falling prices. A 2009 estimate put Iran's break-even cost of its oil production at US$ 90 per barrel.

It is likely that Iran is a target of the Saudis move to depress oil prices.  If this is the case, one of the biggest impacts from Saudi Arabia's decision to keep pumping oil may be the fracturing of o.p.e.c. Divisions between the low-cost oil producing nations led by Saudi Arabia and the high-cost producing nations led by Iran will become increasingly stark.

Undoubtedly the 27 November's decision by O.P.E.C. not to cut production in the face of plummeting oil prices will have a major impact on the energy industry, with possible significant ramifications for the global financial system as well.

Immediately on the news that O.P.E.C. will maintain production levels at 30 million barrels a day, the price of oil fell further, bringing the total decline to almost 40 per cent since June 2014.

The oil price fall is a product of two factors: increased U.S. production from the exploitation of shale oil, and falling growth and stagnation in much of the world economy, which has led to a decline in demand. The falling price will be compounded by the Saudi-led move, which is clearly directed at undercutting the U.S. shale oil industry.

The decision's most immediate consequences will be felt in Algeria, Iran and Venezuela, where government revenues depend on oil prices remaining at around the level of US$ 100 per barrel, where they sat from 2011 until the slide began in June 2014.

Algeria and Venezuela were insisting for production cuts by O.P.E.C. of around 2 million barrels per day.

A significant change has come over energy markets since 2011. The extraction of shale oil and gas in the U.S. has largely taken it out of the market as an energy importer. Imports are predicted to provide only 21 per cent of U.S. liquid fuel consumption in 2015, compared to 60 per cent in 2005.

But the expansion of the costly shale oil extraction industry was predicated on oil prices remaining above around US$ 80 per barrel. Once the price starts to fall below that level, marginal producers are seriously impacted.

O.P.E.C.'s decision may have been taken with the express purpose of further lowering prices in order to harm the U.S. industry. This is a tactic being pursued in the iron ore market where low-cost producers, such as BHP-Billiton and Rio Tinto, are increasing production levels, even in the face of a declining market, in the hope of forcing higher-cost producers to the wall.

The aggressive intent of the Saudi actions was the theme of a number of comments on the decision. Kuwaiti Oil Minister Ali Saleh al-Omair said that O.P.E.C. would have to accept any market price, even if it were as low as US$ 60.  Others were even more blunt. “We interpret this as Saudi Arabia selling the idea that oil prices in the short term need to go lower, with a floor set at US$ 60 per barrel in order to have more stability in the years ahead at US$ 80 plus.” according to a Petromax consultant. “In other words, it should be in the interests of O.P.E.C to live with lower prices for a little while in order to slow down development projects in the United States.”  Research by JP Morgan Asset Management concluded that of the 12 largest shale oil basins in the U.S., some 80 per cent are barely profitable at prices lower that US$ 80 per barrel.

* * *

Only a few years ago, many observers expected a steadily growing global shortage of crude oil. This shortage did not materialise in part because of the rapidly growing production of shale oil in the U.S. The production of shale oil   -   also referred to as tight oil   -   exploits technological advances in drilling. It involves horizontal drilling and the hydraulic fracturing   -   or ‘fracking'  -   of underground rock formations containing deposits of crude oil which are trapped within the rock. This process is used to extract crude oil which would have been impossible to release by conventional drilling methods designed for extracting oil from permeable rock formations. Shale oil production relies on the availability of suitable drilling rigs and skilled labour, which is one of the reasons why the U.S. shale oil boom so far has been difficult to replicate in other countries.

U.S. shale oil production has grown from about 0.4 million barrels a day in 2007 to more than 4 million barrels a day in 2014. This expansion was stimulated by the high price of crude oil after 2003, which made the application of these new drilling technologies cost competitive. The expansion of U.S. shale oil production soon captured the imagination of policymakers and industry analysts. The International Energy Agency projected that by 2012 the U.S. would have become the world's leading crude oil producer, overtaking Saudi Arabia by the mid-2020s and evolving into a net oil exporter by 2030.   Analysts anticipated the U.S. becoming independent of oil imports, net oil exports financing the U.S. non-oil trade deficit, and consumers enjoying an era of cheap petrol with a resulting rebirth of U.S. manufacturing.

To gauge the importance of shale oil for the U.S. economy it is useful to bear in mind that, as at March 2014, shale oil accounted for almost half of U.S. oil production, but only about a quarter of the total quantity of oil used by the U.S. economy. This magnitude is far from negligible, but to understand the enthusiasm about shale oil one has to consider projections of future U.S. shale oil production.

The production of unconventional oil, including offshore drilling, tar sands, hydro-fracturing to produce shale oil and other expensive techniques, was lavishly financed in order to make up for the shortfall. The reality is that the recent energy boom was financed by US$ 500 billion of credit extended to mostly ‘subprime' oil companies, which issued what are politely termed high-yield bonds  -  to the point that 20 per cent of the high-yield market is now energy-production-related.    And ‘high-yield' is code for junk.   So, a ‘subprime' oil crisis may be looming.

But at the moment most unconventional oil costs more to produce than it can be sold for. This affects several countries, including Canada with its tar sands, Mexico with its offshore production, Nigeria, Norway and Venezuela with its  heavy oil, which requires upgrading before it will flow, and, of course, shale oil in the U.S. All of these countries' producers are now losing money as well as much of the oil they produce and, if the low oil prices persist, will be forced to shut down.

In Canada and Mexico, two major oil exporting nations, the lower oil price is also a mixed blessing.

In Canada, the oil sands have among the highest all-in-cost of production   -  even higher than U.S. shale oil. The advantage Canada has is that oil sands operations are more like mining operations. Once the mines are built, they produce the oil relatively inexpensively for up to 30 years or more. So even with prices so low, the oil will continue to flow. However, new projects will be put on hold. In contrast, shale oil wells produce about 90 per cent of their oil their first year and run dry after three years. So, if oil prices do not improve quickly, these U.S. based competitors will be the first to go bust.

Oil producing provinces like Alberta, Saskatchewan, Manitoba and Newfoundland will be hit the hardest. Provincial collections will be smaller than expected.

On a federal level, the value of the Canadian dollar is falling alongside the price of oil. In the short term this will give a boost to the manufacturing export sector. Ontario, which is a large oil consumer and home to Canada's industrial heartland, will benefit from low oil prices the most. Here again, Americans will lose as less expensive Canadian imports move south of the border.

In Mexico, the low oil price could hit home with a devastating punch. The energy sector accounts for a full 13 per cent of Mexico's economy. Much of Mexico's oil production is pricier than Gulf oil which comes from aging oil fields. The longer prices stay low, the greater threat these fields will come under. Additionally, oil accounts for 32 per cent of government revenue   -   and the Mexican government has based its 2015 budget on an average price of US$ 79 a barrel. Lost jobs and reduced government spending could lead to growing social instability.

But as important as oil is to North America, taken together, Canada, Mexico and the United States are not only close to energy self-sufficient, but close allies.

An additional problem is the very high depletion rate of ‘fracked' shale oil wells in the U.S. Currently, the shale oil producers are actively pumping and setting new production records, but the drilling rate is collapsing fast. Shale oil wells deplete very fast: flow rates go down by half in just a few months, and are negligible after a couple of years. Production can only be maintained through relentless drilling, and that relentless drilling has now stopped. Thus, there might be just a few months of glut left. After that, the whole shale oil revolution, which some analysts thought would refashion the U.S. into a new Saudi Arabia, will be over. It will not help that most of the shale oil producers, who speculated wildly on drilling leases, will be going bankrupt, along with exploration and production companies and oil field service companies. The entire economy which developed in recent years around the shale oil patch in the U.S., and which was responsible for most of the growth in high-paying jobs, will collapse, causing the unemployment rate to spike.

US Shale plays. Source EIA.

United States shale plays. Source Energy Information Administration.

In the years following the 2008 ‘financial crisis', shale oil revolutionised America's economy. And in 2013, according to Bank of America analysts, the United States overtook both Saudi Arabia and Russia to become the world's largest oil producer.

This radical development was made possible by ‘fracking' technology. It allowed companies to get oil from shale rock. The same technology allowed America to become the world's largest natural gas producer in 2010.

The shale oil and gas revolution has been the nation's biggest single creator of full-time, middle-class jobs since the 2008 economic debacle. Nearly 1 million Americans work directly and 10 million indirectly in the oil and gas industry.

But the United States' energy boom was predicated on oil prices which no longer exist.

The average mid-cycle break-even price of a shale oil company operating in the North Dakota's Bakken field is US$ 69 per barrel, according to analysts at Scotiabank. The break-even cost in the Permian Basin in Texas comes in at US$ 68 per barrel, the Niobrara   -   which extends to Colorado, Nebraska and Wyoming   -  at US$ 59; and the Texan Eagle-Ford at US$ 50.

Four of the seven shale gas basins are already in terminal decline as far as their well productivity: the Haynesville Shale  -  which underlies large parts of southwestern Arkansas, northwestern Louisiana, and eastern Texas; the Fayetteville Shale  -  which underlies much of northern Arkansas an adjacent states; the Woodford Shale  -  which is located in southeastern Oklahoma; and the Barnett Shale  -  which is located in the Bend Arch-Fort Worth Basin in Texas.

Today, that oil can only be sold for around US$ 56 per barrel.

On the other hand, the United States is betting that the low oil prices will destroy the governments of the three major oil producers which are not under their political and/or military control. These are Iran, Venezuela and, of course, Russia.

Iran has learned to survive in spite of ‘western' sanctions, and maintains trade links with China, Russia and quite a few other countries to work around them. In the case of Russia, it is as yet unclear what fruit, if any, ‘western' policies against it will bear. As for Venezuela, the future is grim.

Of course, toppling the governments of all three of these petro-states, destroying them economically, ‘privatising' their oil resources and pumping them dry free of charge using foreign labour would be just the shot in the arm that the United States may  need. But not always the United States gets what it wants, and of late hardly at all.

Sustained production requires ongoing investment. Projections by the U.S. Energy Information Administration suggest that even under favourable conditions U.S. shale oil production will peak by 2020   -   at a level commensurate with U.S. oil production in 1970   -    and then decline. Moreover, even the peak level would be far below what is needed to satisfy U.S. oil demand.

What is not known is how vulnerable the shale oil industry is to downside oil price risk.  This concern has become particularly relevant in recent months with the rapid decline in global oil prices. Shale oil production remains profitable as long as the price of oil exceeds marginal cost. There are indications that the initially high marginal cost of shale oil production has been declining substantially, as the shale oil industry has gained experience, but there are no reliable industry-level estimates of marginal cost.

In short, there is considerable uncertainty about the persistence and scope of the U.S. shale oil boom, and there are many reasons to be skeptical of the notion that the U.S. will soon, or indeed ever, become independent of oil imports.

Despite all such uncertainties one thing remains clear: today the United States is the third-largest oil producer, slightly behind Saudi Arabia and Russia, with U.S. crude oil accounting for about 10 per cent of world production. Much has been made of the possibility of the U.S. overtaking Saudi Arabia as the largest oil producer in the world, as the production of shale oil continues to surge. The implicit premise has been that being a large oil producer ensures a country's energy security. It is easy to forget, however, that the U.S. already was the world's largest oil producer in 1973-1974 as well as in 1990. This fact did not protect the U.S. economy from major foreign oil price shocks, suggesting that the focus on becoming the world's largest oil producer is misplaced. 

It may seem that the rapid decline in the global price of oil after mid-2014 may be attributable to sharp increases in U.S. shale oil production, providing direct evidence of the impact of the U.S. shale oil revolution on oil prices after all. Although shale oil is not being exported, it replaces U.S. crude oil imports, reducing the demand for oil in global markets, as do U.S. exports of refined products. Some observers have gone as far as suggesting that shale oil may have become a victim of its own success in that it caused a sharp drop in global oil prices. There is no credible support for this view.

Still, the collapse in U.S. oil prices, particularly since September 2014, may very soon collapse the U.S. shale oil bubble and tear away the illusion that the United States will surpass Saudi Arabia and Russia as the world's largest oil producer. That illusion, fostered by quesionable resource estimates issued by the United States Department of Energy, has been a lynchpin of the American administration's geopolitical strategy.

The basic economics of shale oil production are being ravaged by the 23 per cent oil price drop since Secretary of State John Kerry and Saudi King Abdullah had their secret meeting near the Red Sea in early September 2014, presumably to agree on the Saudi oil price war against Russia.

* * *

The oil price fall is affecting Russia faster and harder than perhaps any other country. Russia is, in most months, the world's biggest producer, and oil and gas provide its main sources of income. As a result of the price crash and U.S.-imposed economic sanctions, the rouble has dropped dramatically.

Russian oil producers can sell their product in strong dollars but pay their expenses in devalued roubles. Thus, they can make capital improvements, invest in new capacity, or do further explorations for less than it would have cost before the rouble's value was halved against the dollar. The sector remains healthy, and able to continue contributing the lion's share of governmental tax revenues.

The Russian authorities are dependent on oil: about half of budget revenues comprise oil and gas revenues. Furthermore, the state budget of the Russian Federation for 2015 was based on the estimation that the average price of Urals oil would be US$ 96 per barrel. Russia's oil and gas revenues contributed about US$ 73.5 billion annually from 2001 to 2004 to the country's G.D.P. Russia's growing wealth kept going on. From 2005-2008, annual hydrocarbon revenues were US$ 223.6 billion, higher than in 1999 at US$ 45 billion. In 2011-2013 Russia's annual oil and gas income reached US$ 394 billion, above 1999 levels.

Bright days of the Russian economy changed for ‘cloudy weather' with the introduction of sanctions and later with the plummeting oil prices. Russia's finance minister estimates that the country's losses since last spring have surpassed US$ 140 billion. Moreover, the rouble has lost almost 50 per cent of its value over the past six months.

The strengthening of the U.S. currency on global markets, record oil production volumes in the United States and O.P.E.C. countries, combined with falling oil prices, are a threat to the Russian economy. President Obama was well aware of all this when he threatened in the spring of 2014 that Russia would “pay the price” for the annexation of Crimea.

Political observers have suggested that there might be a global oil war underway, with the United States and Saudi Arabia on one side against Russia and Iran on the other.

Regardless of the dynamics of these alliances   -   coincidentally or intentionally   -    the net result has been to make life difficult for Russia and Iran at a time when the United States and Saudi Arabia are confronting both of them in a proxy war in Syria.

It is undoubtedly clear that the price fall serves American and Saudi strategic interests and it harms Russia and Iran. But in the near term, these big producers will probably face budget problems in varying degrees of severity, with an array of economic, strategic and political aftermaths.

It is also likely that Saudi Arabia may allow lower prices to continue, in part to squeeze its main rivals   -   ?Iran and Russia   -   ?and in part to put pressure on shale oil producers in the United States, whose higher production costs make it harder for them to compete when prices are lower abroad.

The reasons behind the Saudis' decision to drive down the oil price are not clear enough, but Russian analysts began to claim that the U.S. and Saudi Arabia are conspiring to bring Russia ‘to its knees'.

Saudi Arabia is generally displeased with the U.S., because the U.S. has been failing at its job of policing the neighbourhood and generally keeping a lid on things. Afghanistan is reverting to Talebanistan, Iraq has ceded territory to I.S.I.S. and now only controls the territory of the bronze age kingdoms of Akkad and Sumer, Libya is in a state of civil war, Egypt has been ‘democratised' into a military dictatorship, Turkey   -  a N.A.T.O. member and a European Union candidate member   -   is now trading primarily with Russia, the mission to topple Syria's Assad is in shambles, the US ‘partners' in Yemen have just been overthrown by Shiite militiamen, and now there is I.S.I.S., initially organised and trained by the U.S., threatening to destroy the House of Saud. Add to that that the U.S.-Saudi joint venture to destabilise Russia by fermenting terrorism in Northern Caucasus has completely failed. It could not organise even a single terrorist action to disrupt the Sochi Olympics. Saudi Arabia's Prince Bandar bin Sultan lost his office as a result of that failure. And so the Saudis are busy extracting not so much to help the U.S. as for other, more obvious reasons: to drive out high-priced producers    -   American included   -    and to maintain their market share. They are also sitting on a huge sum of U.S. dollars, that they want to put to good use while they are still worth something. 

Saudi Arabia met with Russia before the November 2014 O.P.E.C. meeting and proposed that if Russia would cut production, Saudi Arabia would also cut and persuade Kuwait and the United Arab Emirates at least to cut with it. Russia said “No”, so Saudi Arabia said, “Fine, maybe you will change your mind in six months.” Present to the meeting were Saudi Arabia's Oil Minister Ali al-Naimi and senior oil officials from Russia, Mexico and Venezuela. When Russia rejected a suggestion that non-O.P.E.C. members participate in a move to cut production and prop up prices, Saudi Arabia abandoned any plans to rein in its output, opting instead to fight to maintain its position in the market, according to people familiar with Saudi thinking.

It is possible that Russia and maybe Angola, Iran, Nigeria and Venezuela will change their minds by the next O.P.E.C. meeting in June 2015.

The International Energy Agency estimates that oil and gas provide 68 per cent of Russia's exports and 50 percent of its federal budget.

It is difficult to visualise the situation if the government had suddenly to cut its budget by 25 to 30 per cent to pay the bills   -  all the while seeing the value of the dollar evaporate by 60 per cent over a matter of months. This is the situation facing Russia. And it comes as Russia's economy is also being battered by ‘the West's economic sanctions.

In the view of some analysts Saudi Arabia is working in conjunction with the U.S. to drive oil prices down in an effort to bankrupt both Iran and Russia. This is a theme that President Putin has also highlighted.   Asked about the fall in global oil prices, Putin said: “The obvious reason for the decline in global oil prices is the slowdown in the rate of economic growth … [but] in addition a political component is always present in oil prices … derivatives greatly increasing the volatility of oil prices are being actively used. Unfortunately, such a situation creates the conditions for speculative activity and, as a consequence, for manipulating the prices in someone's interests.” [Emphasis added]

On 18 December 2014, in his end-of-the-year speech, Putin said that Russia's existence was on the line: “Sometimes I think, maybe it would be better for our bear to sit quiet, rather than chasing around the forest after piglets. To sit eating berries and honey instead. Maybe they will leave it in peace.” he said. “They will not. Because they will always try to put him on a chain, and as soon as they succeed in doing so they tear out his fangs and his claws. … Once they've taken out his claws and his fangs, then the bear is no longer necessary. He'll become a stuffed animal.” he said. “The issue is not Crimea, the issue is that we are protecting our sovereignty and our right to exist.”

The reality is that Russia can undoubtedly ride out a period of lower oil prices. In fact, such a period is likely to be beneficial in the end.

Sharp falls in European markets and wild swings on Wall Street on 15 December 2014, combined with a further plunge of more than 10 per cent in the value of the Russian rouble, indicate that the worsening global slump is starting to have a major impact on financial markets.

In response to such precipitous fall and the failure of several market interventions that same day the Russian Central Bank took the extraordinary step of raising interest rates overnight from 10.5 per cent to 17 per cent. This was in reaction to a one-day run on the rouble which drove the value of the currency down 13 per cent and an 11 per cent slide in stock prices. Combined, these two changes wiped out a quarter of the dollar value of companies traded in Russian equity markets.

 “The decision was driven by the need to limit the risk of devaluation and inflation, both of which have recently significantly increased.” the Bank said.   Earlier in the day, the Bank warned that the Russian economy could contract by up to 4.7 per cent in 2015 if oil prices remain at around US$ 60 per barrel. The fall could be even larger, because there is no sign the slide is ending. Morgan Stanley warned that the economy would contract by 6 per cent if the price of oil drops to US$ 50.

The Russian budget, and economic projections for 2015, were framed on the expectation that the oil price would stay around US$ 100 per barrel, the level at which it remained from 2011 until June 2014.

It is highly unlikely that ‘western' governments   -   led by the United States and the European Union    -   lift their sanctions against Russia without significant movement from the Russian government. The E.U.'s sanctions will be subject to review later in 2015, and no doubt some member states will be concerned about the negative impact that the current measures are having on their own economies. But the U.S. sanctions are likely to stay in place for some time to come.

The sanctions are aimed at designated individuals, organisations and companies. The E.U.'s sanctions fall into three main areas: financial sanctions against designated Russian banks, energy companies and defence companies; arms embargoes and restrictions on certain dual purpose technologies; and restrictions on exports of high- tech goods and services in the energy sector. In early December 2014 the E.U. clarified the aspects of the energy sector subject to sanctions: 1) oil exploration and production in waters deeper than 150 metres; 2) oil exploration and production in the offshore area north of the Arctic circle; or 3)  projects which have the potential to produce oil from resources located in shale formations by way of hydraulic fracturing.

Russian consumers will be hurt, of course, due to the higher costs of imported goods, as well as the squeeze inflation puts on their incomes. But, by the same token, exports will become much more attractive to foreign buyers. A cheaper rouble boosts the profit outlook for all Russian companies involved in international trade.

Low oil prices are also good for Russia's big customers, especially China, with which President Putin has been forging ever-stronger ties. If, as expected, Russia and China agree to transactions in roubles and/or yuan, that will drive them even closer together and further undermine the dollar's worldwide hegemony.

Russia is still able to rely on a surplus of foreign assets and very healthy foreign exchange reserves of around US$ 375 billion. Moreover, it has a strong debt-to-G.D.P. ratio of just 13 per cent and a large, and steadily growing, stockpile of gold.

And there is Russia's energy relationship with the E.U., particularly Germany. President Putin showed his clout when he cancelled the South Stream pipeline and announced that he would run a pipeline through Turkey instead. The cancellation barely lasted long enough to speak of it before the E.U. offered Putin what he needed to place South Stream back on line. It is not likely that Germany will let Turkey be a gatekeeper of European energy security. With the arrival of the northern winter the E.U.'s dependence on Russian oil and gas would take centre stage, and that would become a stabilising influence on Russia once again.

At mid-December 2014, Russian Foreign Minister Sergey Lavrov, referring to the oil price drop, told French television: “We have been in much worse situations in our history, and every time we were getting out of these fixes much stronger. This will happen this time.”  He was right, of course, about Russian history, which includes amongst other ordeals the incredibly heroic and costly fight against the Nazi-Fascists in the second world war.

The capacity of the Russian people to endure suffering is certainly amongst the highest in the world.

Dr. Venturino Giorgio Venturini devoted some sixty years to study, practice, teach, write and administer law at different places in four continents. He may be reached at [email protected].  






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