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Trading Lessons

Crude Oil And National Security

Politics / Crude Oil Jul 09, 2012 - 07:22 AM GMT

By: Andrew_McKillop


Best Financial Markets Analysis ArticleTHE WIDENING GULF
Oil and national security were at one time treated like they meant the same thing, using the extra loop of logic that cheap oil = economic security. Today, Goldman Sachs, and other major financial market players are pulling out all the stops, using all the tricks to try and stop oil prices from falling. High oil prices are now a critical prop to the world's failing financial, banking, monetary and trading systems.

The 1973 oil shock, starting in October 1973 lasted until March 1974 with oil prices multiplied by about 4.75 (+375%) but more important for its political settlement, it changed the way western politicians saw the role of oil, and the US - which was rapidly shifted to centre stage, by other major importer countries - and set as the main cause of the Arab oil embargo of October 1973. Some European nations and Japan sought to disassociate themselves from the USA's "over supportive" stance on Israel. This pushed the Nixon administration to start parallel negotiations with Arab oil producers to set a rise in prices acceptable to all parties, and start talks with Egypt, Syria, and Israel to arrange an Israeli pull back from the Sinai and the Golan Heights.

Conspiracy lovers can argue the US encouraged, or let Israel sit on its gains from the 1967 war with Arab countries and massively increase these gains with the "Yom Kippur war" of October 1973, knowing the OAPEC states would quite rapidly use "the oil weapon". Much higher oil prices would then provide windfall gains to US oil companies, which at the time controlled a lot more of world oil production, supply and trade, than today. Probably much closer to reality, in August 1971, the United States unilaterally pulled out of the Bretton Woods system and broke the dollar's link with gold set by the gold exchange standard. Rapidly after, Britain followed with a floating pound sterling. The result was a depreciation of the value of all "fiat moneys" including the US dollar, and because oil was priced in dollars, this caused an immediate fall in real income for producers. The OPEC states, in 1971, had already issued a joint communique stating they intended to price oil against gold, thus the scene was set. The 1973 Middle East crisis following the second Arab-Israel war, provided the opportunity for oil producers to act on their published intention and recover their lost buying power: through the entire period 1947–1967, the price of oil in US dollars had risen by less than two percent per year. From 1974 onward, and especially since the mid-1980s as oil trading grew to represent volumes of "paper oil" of more than 200 times actual physical demand and physical oil trade, oil prices could only be volatile, and since 2000, volatile and high.

Probably for more than 15 years, possibly as far back as the 1980s, trying to find hard-edged and certain proof that oil price changes - volatile priced oil - has major negative impacts on the economy of specific countries, groups of countries or the world economy is a losing game. The International Energy Agency, founded by Nixon and Kissinger in the wake of the October 1973 Arab oil embargo, however exists to produce reports and studies to make that assertion but many serious studies of the subject, such as by James Hamilton (1999-2001) come out ambiguous (, especially on the supposed "fillip" to the economy that cheap oil would give.

National security concerns related or linked to oil have themselves mutated away from the narrow focus of supposed negative economic impacts of overpriced oil. For the US, the massive oil spill in the Gulf of Mexico from BP's drilling platform that exploded in 2010 and killed 11 workers, fouled fishing areas and threatened to ruin the region's beaches and tourism industry was arguably a massive jolt to Americans' sense of national security. If anything, the Mocambo disaster generated even larger corporate and political support for shale oil and shale gas development and production in the US, as the role of deep offshore oil in US total production declines on an accelerating basis.

Rather than strategic fear of dependence on foreign oil, both the US and other major oil-using economies now have declared policy targets on reducing economic dependence on oil. The difference is large. Oil saving and substitution builds on always-existing but never applied policies that were first set after the October 1973 crisis. At the time, using IEA data, the OECD group of countries depended on oil for 52.6% of their commercial energy. Today's OECD, which now includes oil intensive economies such as South Korea and Mexico, depends on oil for under 36% of its commercial energy. Also using IEA data for 2011, with oil prices often nudging $120 per barrel the cost of oil imports for the US, Japan and the EU27 states ranged from 2.2% to 2.7% of GDP: claiming this permanently threatens the economy is stretching the imagination.

Certainly in the 1970s and 1980s, arguably as late as the 2003 invasion of Iraq on the pretext that Iraq held stocks of weapons of mass destruction, the belief that ensuring oil supply security is a military priority was a clear and stated NATO rationale. Today however, breaking oil addiction is an economic mission, which in the case of the EU27 countries is the formal basis of their common energy policy, the "climate energy package" since 2008. The US in many ways has the same set of policies (however badly they are applied) in the shape of its 2007 EISA.  Showing the "all party nature" of these policies, the goal of backing oil out of the energy mix gets approval from almost every possible shade of political opinion ranging from extreme left to extreme right.

 Ask Goldman Sachs. Outside the banking, brokering and trading reasons for expensive oil, the world's energy corporations - and especially the former Seven Sisters (now the 5 Dwarfs) - are making a de facto accelerating shift away from oil. One simple reason is that finding and producing new oil tends only to get more expensive and slower, and gas-based oil from condensates is the de facto largest source of new supply. Also simple, paying for the gas shift (driven by vast new finds of gas on the resource side) needs the "corporate subsidy" of high earnings from oil, making it advantageous for Big Energy to allow their oil exploration and production effort to produce less and less new oil - which is easy due to its ever rising cost per incremental barrel.

Exploration and production spending, we can note, really is price elastic: when oil prices drop, oil E&P declines rapidly, with today's probable hinge point for a major cut in E&P not far below $75 a barrel.

Cheap oil is now defined by this price range, which in inflation adjusted terms using US Commerce department data, is equivalent to an oil price of much less than $20 per barrel in 1980 terms. This in turn means that any time global oil demand recovers or "bounces", prices can only spiral, resulting in further cross-party and public opinion support to backing oil out of the economy.

This locked-in support to "the end of oil" will surely make the world a less dangerous place, but the financial impact will be dangerous, as Goldman Sachs can also explain. The previous paradigm of Dangerous Oil held that "America's billion dollar a day dependence on oil makes us vulnerable to unfriendly regimes (because) a substantial amount of that oil money ends up in the hands of terrorists", as the Website for the Truman National Security Project's "Operation Free" says. The new paradigm says oil is not a critical basic need for the economy, is usually overpriced, and real alternatives exist.

 The message in the US is now made by high-ranking military persons who commanded large segments of the U.S. Army, Air Force, Navy and Marine Corps both in Afghanistan and Iraq. Despite this sign of how the "clean energy message" is growing and spreading, oil is however now a critical financial asset for weakened banking and related financial entities; any prolonged period of falling oil prices, driving a fall in other commodity prices, and linked equity prices, will produce a totally predictable rout of failures and bankruptcies in the hedge fund "community" and further up the pile, to major brokers like MF Global, to even threaten Goldman Sachs itself.

In a real way, today, not only the euro but also the US dollar depend on relatively high oil prices (and linked assets, including equities): the current financial and fiscal crises of OECD countries will worsen, if oil prices fall below $60 - $75. The economic rationale for this is that major importers of OECD goods and services like Russia and the Arab states totally depend on oil revenues - due to never having bothered to develop their economies away from oil.

One simple and direct reason for the financial, fiscal and monetary dependence on high priced oil are petrodollar and petroeuro surpluses. In the US case, critical money system entities such as the Federal Reserve Bank of NY now depend on these capital surpluses, which will dramatically shrink when oil prices fall. Other central banking entities, including the IMF, Europe's ECB and European state central banks also depend on oil-related capital desposits and flows - notably because of the almost formal "gold-oil standard" or price linkage. If this is broken, another link in the world's very fragile central banking and monetary system will fall.

Just like "confidence" and the lack of it drives the present and continuing European rout, oil prices are finally only able to hold up if there is "confidence" in it. Oil must be believed to be impossible to substitute, critical to the economy, a sure financial resource and other would be's - but in all cases these are outdated notions.

The present weak and unconvincing nature of global economic "recovery", more than 3 years after the 2008 crisis started, has been bad for oil myth. Unlike official data from the IEA and US EIA,  global oil demand's supposed recovery in 2011 was at best very weak, and may have been statistical illusion. For the EU27 states, 2011 was like any other year since 2006 - their oil demand continued declining at an average annual rate of 2.5%. As the years stack up, the losses for oil stack up. The major difference beween 2006 and any year following 2008 is this: in 2006, there was no recession.

The real nature of deindustrialization, outplacement and delocalisation has been the production of industrial goods in China, India and other Emerging economies, for use and consumption in OECD countries. The oil demand for their production, and transport, was therefore also delocalised. Taking the marine transport component of this transferred oil demand, it now totals around 2 billion barrels a year, with a decade long growth rate average of 7% a year, until 2009.

No economics genius is needed to say what happens to this oil demand as country after country in the EU27 slumps into recession, and the US "recovery" stays what it is: an inverted commas recovery. As we know, both China and India are now slowing, and little will prevent them continuing to slow: the potential for outright decline in global oil demand is therefore stronger even than in 2009. In all logic, oil prices should fall, making the current antics of the oil market an interesting spectacle, where market riggers struggle to prop up prices every day.

According to several analysts and historians, the global warming and climate change theme, and so-called crisis, was developed as a hidden means of support for further shifting energy policy away from oil, and other fossil fuels, towards renewable energy. Today, this scare-and-fear theme is no longer needed to prop renewable energy, and is itself rapidly losing all credibility among public opinion.  Alternate energy in a fast growing number of domains can now beat oil on basic economic grounds, when and if all all the diseconomies of and subsidies to oil are entered to the account.

Energy independence was at one stage "only" vital for national security, but this is moving to energy independence becoming vital for economic survival in the most dangerous global economic context that has ever existed. The coming fall of oil prices will be a major stage in this transition

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2012 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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