Author: charles@petroleumengr.com

The critical nature of oil to modern economies and the huge size, extent, and nature of the open worldwide oil market in international trading, the divergence of concerns between large oil producer countries and large users  have tightly intertwined effects of US foreign policy, financial policy, energy policy, and oil policy and the effects of oil policy on our economy.  This has been the situation for decades but the US seems to have no overall strategy for guiding and coordinating these various individual policy elements .   International financial, economic, and political systems are in a state of transition but policy makers seem not to understand the role of the oil markets on these systems.

For those of us who were around in the 1970s and remember the so-called Energy Crises of that period this brings up a feeling of “It’s Déjà Vu all over again!” (with apologies to Yogi Berra) because the turmoil, instability, and lack of coordinated government policies are reminiscent of the chaos, confusion, and profound changes of the 1970s.

The State Department refuses to become involved in transactions, relationships, or disputes between American companies and foreign governments.  The most egregious example of this policy was in the early 1970’s when Saudi Arabia was considering increasing the price of oil and removing the American companies who founded and owned Aramco from their ownership position.  The State Department sent an Undersecretary, John Irvin, to Saudi Arabia to assure the Saudis that the US Government would not support the American companies in their negotiations with the Saudi government thus rendering the companies defenseless.

The Saudis repaid the favor by increasing prices repeatedly to a level over fivefold previous prices, profoundly impacting the economies of the US and Europe, (which Henry Kissinger described as “one of the pivotal events of this century” which “altered the world irrevocably”  and for which the American public blamed the oil companies), and then imposing an Oil Embargo on shipping Saudi oil to the US.

US Government representatives, led by Henry Kissinger as National Security Advisor and then as Secretary of State, had no understanding or reliable data regarding the oil industry or how it functioned as a basis of their policy decisions.  They then panicked in the belief that the US faced a shortage of oil which would have catastrophic effects on the US economy and enacted a series of counterproductive policies throughout the 1970s ranging from 55-mph speed limits and 17 tiers of oil prices to allocation of gasoline to individual gas stations.  All unnecessary.

Several years later I had the opportunity to discuss that situation with Mr. Kissinger and I made the remark that during the 1970s there never was a shortage of oil.  He answered that yes, he knew it but he “did not know it then”.   In his memoirs (Years of Upheaval) he commented:

“The structure of the oil market was so little understood that the embargo became the principal focus of concern.  In fact, the Arab embargo was a symbolic gesture of limited practical importance. “ and  “the embargo was an inconvenience and an insult; it did not hurt us significantly.”  He also refers to the “never-never land of national policymaking” with respect to expectations of oil availability.

The international oil business profoundly affects us all but nobody in government seems to want to recognize it, talk about it, or consider it when making policy decisions nor seems qualified to do so.  Geopolitically and geoeconomically it is truly the proverbial elephant in the room that no one wants to see; probably because they do not understand it.

In the 1970s policy choices were made in the belief that the US faced a crippling oil shortage when there was no shortage.   Currently the common belief is that there is a Glut of oil and the US can become energy independent based on the success of the “unconventional shale” oil development.  As in the 1970s policies are being proposed based on erroneous perceptions; as I have commented before, the Glut is based on bad data and hard to find and the US will not be energy independent with respect to oil.

Henry Kissinger asked “Does America need a Foreign Policy?” as the title of a book published in 2001.  By asking the question, Mr. Kissinger made it apparent he did not think the US had a foreign policy; sixteen years later it is no more apparent than it was then.  Since the end of the Cold War 25 years ago our foreign actions seem to have no overriding guiding principles nor do they seem to have any coordinating oversight of actions by various government policy makers.  We react impulsively to some crises and not others in a willy-nilly fashion.

The US currently maintains a strong military presence in the Middle East to assure a stable oil supply, market, and price system for the world.  In an open world market what happens in any part of the world changes the price everywhere so prices react to any influences anywhere.  Many of those influences are based on bad data or foreign conflicts and whipsaw our economy between high and low prices punishing either consumers or investors.  Because the US imports 8 million barrels of oil per day we expend our resources and effort trying to bring order to a chaotic and violent part of the world.  The Middle East is an endless source of conflict and instability and our efforts and resources disappear into the sand with little effect and earn us nothing but resentment and criticism.

The rest of the world gives us little or no support and is getting a free ride on our military presence and efforts.  Russia and China are establishing influence on various parts of the supply system.  Europe has become a charming museum capable only of endless hand-wringing in response to any crisis and whining about whether it can count on the US to take care of it.  China is using their free ride and our money to build a large manufacturing economy and challenge us for dominance.

Although the Arab oil embargo did not hurt us, the actions taken and policies enacted in response did; many of which are still in effect and we still live with them even though they were the result of a lack of understanding of the situation.  Those policies are now becoming obsolete and the US needs a new system of sustainable and reliable oil supply and price.

The US needs to establish a new strategic system to coordinate foreign, financial, political, economic, and oil policies and take charge of its future.  Such a system will require close coordination by foreign, financial, and energy policy makers; it must be overseen by people knowledgeable in geopolitics, geoeconomics, international finance, and the international oil business and markets.  It must not be established or directed with a lack of understanding of the “oil market” as in the 1970s as described by Mr. Kissinger.  We need new policies; we cannot afford to make the same mistakes again.  We must take charge of our oil supplies; oil is too critical to a modern economy for us to leave our supplies to chance.

To assure a sustainable stable oil price and supply system and an attractive investment climate for oil development without the burden of trying to deal with the Middle East, the US should reduce its dependence on a world oil market and price system by establishing a regional system with our neighbors in North America; Canada and Mexico, both large producers, are also not served well by the current open worldwide market.

Colombia is a long-time friend with large oil resources; it is trying to end decades of civil violence with Communist guerillas and might welcome the chance to join such a regional, reliable oil market and price system which would attract investment.   The current Venezuelan government and its socialist paradise of poverty, repression, and starvation will finally come to an end – the Russians, Chinese, and Iranians will not prop it up forever.  Its successor might also like to join such a stable system and re-establish Venezuelan prosperity.  Such a system would have enough oil for its participants’ needs for decades to come.  The supply and market systems would be managed by an independent commission similar to how the Railroad Commission of Texas managed the supply, market, and price system of the US for four decades.

Such an independent, regional, oil supply and market system would have the following advantages:

1. Establish a stable supply, market, and price structure for oil supply and income for its participants which would be separate from and independent of the current worldwide system with its strains, influences, and price volatility and vulnerability to manipulation.  Such a stable and open investment climate would attract investment to develop the resources of the participants.
2. Greatly reduce, although probably not eliminate, the need for US involvement in the Middle East.  By removing the US from the international market for oil, the US would no longer be vulnerable to oil price fluctuations caused by Middle East turmoil, bluff, war, intimidation, or manipulation by competitors.  The US would then no longer need to protect oil supplies which are mostly for Europe, China, India, and Japan.
3. The US, without the need to consider international oil market effects on the dollar, can selectively choose its trading partners.  Currently, the US trades with, and therefore finances, several adversaries – we can quit making our enemies rich.
4. Reduce Iranian, Russian, and Chinese involvement and influence in Latin America and terminate Iranian access to their missile bases in Venezuela and Nicaragua and reduce support to the communist governments of Nicaragua, Cuba, Ecuador, and Bolivia.

 

The United States now finds itself one of the three largest oil producers in the world.  The other two, Russia and Saudi Arabia, are both large exporters of oil while the United States is also one of the largest importers of oil in the world along with China.  Russian, Chinese, and Saudi Arabian oil companies are all government-owned and operate as agents of their governments.  United States oil companies are owned and managed by private enterprise.  Most of the advanced industrial economies of the world are large importers of oil and produce very little; most of the large oil producing countries are large exporters and use less than half of their production.  The United States is uniquely on both sides of this situation.

The international oil markets and price system is a system to effect an orderly and reliable purchase and sale process between importers and exporters of oil because the importers need a steady supply of oil to operate their advanced economies and the exporters need dependable payments as they are a significant part of their national economies.

The system was established in the early 1980s in response to the Decade of Confusion following the 1973 Arab Embargo and served the world reasonably well for many years in which the industry had a significant production surplus capacity compared to world demand.  As world demand grew and reached the capacity of the industry to produce, for the first time in history, during the first decade of this century, oil prices became volatile.  Slight shortages or surpluses of supply generate large swings of price in an open marginal pricing system for a commodity of critical importance to both sides of the transactions.  These swings can manifest on a short-term basis as evidenced by a price drop of approximately 60% to 80% in 2014-15 associated with a surplus of about 1.5%.

As both a large producer and importer, this price volatility does not serve the US well.  Investors in domestic production need a reliable return on their investment.  Low prices for petroleum products may benefit certain parts of the economy and please consumers but will not sustain the investment needed to maintain or increase production.  As noted in an earlier commentary, companies engaged in current development of unconventional domestic US oil resources are not reporting financial results that indicate investors in the current drilling surge in the Permian, Eagle Ford, or Bakken areas will be repaid.  The number of active rigs drilling in these areas is declining; if this trend continues, US production will start to decline in 4 to 6 months.  Expectations of large US production increases and US independence from imports are unrealistic; it will not happen.

High prices stimulate expansion of domestic development but are harmful to other parts of the economy and, in a worldwide common market, also generate expansion of international supplies which in turn contribute to a subsequent drop in prices.  Volatility and uncertainty with respect to oil prices are detrimental to the overall economy and generate harmful political policy responses.

While the United States is in a strong position with respect to domestic oil supplies it should revise its international supply and pricing situation for its imports.  Because the international oil markets are so closely intertwined with financial and political systems such a revision means US energy, foreign, and financial policies must be closely coordinated in an overall strategy for the country’s security and prosperity.

Since the end of the Cold War 25 years ago our foreign policy seems to be a series of impulsive reactions to crisis situations anywhere in the world in an ad hoc manner with no consistency as to where or when we get involved or any clear objectives, or whether the response serves any particular interest of ours.  Most recommendations and considerations in foreign policy journals concern micromanaging our involvement in some limited crisis but offer no overall guidance other than trying to maintain the Status Quo with respect to international political and financial institutions established after World War II.

But “Status Quo is the Way to Go” is hardly an effective strategy in a world in which the international political and financial systems are in a stage of considerable instability, upheaval, and transition.  It certainly does not seem to be an effective policy with respect to a 35-year-old oil market and pricing system which was established under considerably different international political and financial conditions in a period of large surplus production capacity.  The existing oil market supply and pricing system no longer serves us well and is under threat of re-alignment by various major players which can have a major effect on the US economy.

The Russian economy was significantly harmed by a combination of the oil price decrease and the US and European sanctions imposed following the takeover of Crimea.  The oil price drop was a reaction of the international pricing system to various financial events and was compounded by the sanctions which were a deliberate focused action taken against Russia; they obviously generated considerable resentment.  After observing Mr. Putin for 17 years it is obvious he is not given to threats, bombast, tantrums, or public announcements when confronted; he decides what to do and does it and his strategy and policies must be inferred from his actions.

Hardly a week goes by without announcement of action by Rosneft, or occasionally Gazprom, or the Russian government with regard to buying part of a foreign company, loaning money to a foreign government, assisting with a construction project, negotiating a merger with a foreign company or other action all of which involve governments of large oil or gas producing countries, or their companies, or oil or gas transportation infrastructure.  Most of these involve resources and facilities to supply Europe but some, such as Venezuela, involve supplies commonly sent to the United States.  Mr. Putin has established a reputation of reliably doing what he says he will do; thus he is making deals with long-time US allies such as Israel, Egypt, and Turkey, in countries where we dominated the industry for decades (Venezuela, Saudi Arabia), and in countries where we have spent blood and treasure (Iraq, Germany) as well as with our adversaries.  He is using his oil companies as instruments of foreign policy.  Mr. Putin does not intend to continue being a victim of others’ policies in a worldwide oil supply and pricing system; he obviously is putting himself step-by-step in a Dominant position to decide what oil prices will be in a large part of the world supply and market system; including Russia.

China also is regularly making purchases and investments in oil and gas fields throughout the world.  China’s acquisitions seem more widespread, designed to establish a presence everywhere rather than with a particular focus.  This week’s announcement is that China bought Glencore’s interest in Rosneft giving it an interest in the Russian strategic program.  Chinese companies are difficult to compete against for acquisitions because they do not seem to concern themselves with typical investment criteria such as Return on Investment, environmental protections, or local corruption problems as must concern private enterprise companies; they are simply buying supply.

China announced it is preparing to open trading of an oil contract in Shanghai in yuan backed by gold.  China already imports oil from Russia and pays in yuan which Russia then uses for purchases of Chinese goods.  China is also negotiating with Iran and Saudi Arabia to pay for its oil with yuan.

Iran has established close relations with several Latin American countries and is poised to take a more active role in their affairs after some of the current turmoil passes.

Last week, US Treasury Secretary Mnuchin announced that in order to pressure China to take actions against North Korea “we will put additional sanctions on them (China) and prevent them from accessing the US and international dollar system”.  This is an action that may have more negative repercussions for the US than for its target China.  If China cannot participate in the international dollar system of payments for international commerce, Chinese trade with the US and Europe will be effectively stopped.  Such a halt will cause a significant disruption to US and European economies until alternate systems of payment are established.  This is not a policy which seems to be part of a long-term strategy.

China has been working with Russia and Iran and others to establish an alternative payment system not based on dollars.  So far, they do not have this system working but if China is cut out of the international dollar system it will be a great incentive to get this alternative system up and running quickly; thus undermining the dollar as the international reserve currency.  With all the trade between Europe and China will it be very long before Europe is amenable to a payment system in yuan?

United States policy seems to be to continue propping up a rickety system where oil prices are determined by traders relying on bad data, rumors, and fantasies who overreact to small variations of supply and demand in a market in close balance causing considerable price volatility between high prices which penalize customers and low prices which penalize investors in the industry.  This system is obsolete.  It not only does not serve the US economy or oil companies well but it does not serve our friends, allies, neighbors, or our competitors well either.

Our competitors are taking action to revise and realign the oil markets and the pricing system – to their benefit.  They coordinate their government policies and company actions.  If they are successful they will come to dominate the supply and price system from which the US obtains its imported oil – now about 8 million barrels per day and expected to increase.

The US needs to take the initiative and pre-emptively establish a reliable, stable, supply and fair pricing system for itself – and a few friends and neighbors.  We either control our destiny or someone else will.  Establishing such a system will need to be a coordinated set of actions by many companies guided by an overall strategy and that strategy should be part of a comprehensive foreign policy.  We have the expertise to do it.

 

Progress in the Energy Dominance Sweepstakes since my last commentary:

Rosneft, Russia’s international oil company, bought Essar, a large Indian refining company, strengthened its relationship with the Libyan faction operating its largest oil field and a major oil export port, and continues to negotiate with PDVSA, the Venezuelan national oil company, to take over several fields.  These are all moves to expand Russia’s influence in the worldwide oil industry; Rosneft acts as an instrument of Russian government strategy and policy.

The US prevented Rosneft from taking control of CITGO, a Venezuelan government-owned company in the US, blocked CITGO from sending its dividends to Venezuela, and prohibited American companies and financial institutions from participating in PDVSA financing; these are all defensive actions.

American companies, as private enterprise organizations, are limited as to transactions in which they can engage with foreign governments without US Government support – a support which has rarely, if ever, been forthcoming.  On the contrary, US State Department actions are generally deliberately neutral or taken in opposition to US companies in relations with foreign governments.

A review of second-quarter financial results for American companies active developing unconventional or “shale” oil reservoirs brings into question whether this sector of the industry can continue to grow and increase US production as contemplated in the announced policy of establishing worldwide Energy Dominance by the US.  It is becoming apparent that although some of these companies may be able to produce profitably at current oil prices, the capital provided by debt and equity investment for drilling and fracturing programs to develop the fields will likely never be repaid.

This realization is becoming widespread among financial institutions; as investors realize they will not recover their investment, it can be expected they will stop investing, drilling and fracturing unconventional reservoirs will stop, and US production will decline.  Development of unconventional reservoirs as a basis of significant further US production growth seems unrealistic.

In addition, the Energy Information Administration continued its practice of revising its weekly production figures downward and corrected its May figures by nearly 200,000 bopd and June figures by 220,000 bopd and June showed a decline from May.

So the US is not producing as much as previously thought, its production is declining, and field development for production increases is not profitable – not an optimistic outlook for establishing Energy Dominance by exporting oil worldwide.

Following the price drop in 2014 and 2015 more than 200 oil companies entered bankruptcy and the number of active US drilling rigs dropped from nearly 1600 to a little more than 300 in a year and half.  Numerous international long-term capital projects were cancelled.  Without continued drilling US production rate declined at an annual exponential rate of about 9 ½ %.

When the oil price seemed to stabilize in mid-2016, the number of active drilling rigs started to increase, dominated by activity in the Permian Basin of West Texas and SE New Mexico.  Companies revised their cost structure and concentrated their engineering and operational management attention on operating cost reduction.  Most companies entered a program of debt and equity re-structuring.  In many cases, former equity holders became severely diluted and debt holders became new equity holders as part of debt re-structuring.  Managements announced they could operate profitably with oil prices at various levels between $40 and $50 per barrel.

As noted above, at current oil prices evidence that these assertions are accurate is rare.  Financial results show recovery of capital for development costs is not a reasonable expectation.   Companies are again increasing debt for capital to pay for development programs.  Free cash flow is not a common characteristic of the financial results of this activity.

Commodity Oil Pricing System

On 30 March 1983 a contract for 1000-barrels of West Texas Intermediate Oil stored in a tank in Cushing, Oklahoma, started trading openly on the New York Mercantile Exchange.  This was the critical event in response to the pricing and marketing chaos of the preceding decade accompanying the so-called “Energy Crises” and loss of control of oil markets and prices by the international major oil companies; it established an orderly and transparent market and quickly caused significant oil price decreases.   This was followed by oil contract trading on the International Commodities Exchange in London and elsewhere, and later by a natural gas contract on the NYMEX.

The start of oil trading on the NYMEX was one of the most significant events in the history of the oil business.  It established an open pricing and trading system with a worldwide market of a fungible commodity and was one of the events that ushered in an international trend to general trade globalization.

Within a short time, the price of “WTI” became the quoted oil price in the US and determined the price of oil throughout the world although the Brent price quoted in London gradually came to dominate international transactions.  Oil pricing acquired the financial and pricing characteristics of all commodities:

1.  All commodities whether an airplane seat-mile, a personal computer, a gallon of milk, a pound of copper, or a barrel of oil, require large up-front capital expenditures; few of those traded on open markets return the investment of the up-front capital investors.   Commodity production is generally over-invested in times of shortage and high prices which leads to over-supply and low prices; only low-cost producers then survive.  Up-front capital investors lose.
2. Open market commodity bidding leads to marginal pricing; the last trade determines the price of all units of the commodity world-wide.  Such markets are volatile depending on perceptions of small surpluses or shortages by market traders.  The price to buy the last oil barrel at any time is the price of any barrel and all barrels; the last trade of the day of WTI on the NYMEX is that quoted in the Wall Street Journal the next morning.

These two characteristics are interconnected.  Marginal pricing causes high commodity prices as long as a shortage, no matter how small, is perceived.  These high prices attract capital investment.  The capital investment increases commodity supply but when a surplus supply situation is reached, even by a small margin, commodity prices drop significantly.   (Recent low prices in the oil industry are associated with a surplus supply of approximately 1.5%).  Companies which remain in business are those with low operating costs.  Competition for survival among suppliers is based on operating cost.  The investors providing capital for the development of the sources of supply typically do not recover their investment.

Once capital investors realize they will not recover their investment, they will discontinue their investment in these programs, the number of active drilling rigs will decrease again, and US production will again start to decline; probably at an annual exponential rate of about 9 ½%.  Fantasies about US Energy Independence or Dominance will then be replaced by concerns about supply shortages and disruptions.

At that point, foreign suppliers will regain control of oil prices and markets; prices will increase significantly.  The US will then again become a victim of an oil market and volatile price system it created, but is now manipulated by adversaries.   A pricing system subject to rumors as to the actions of OPEC quota cheaters, the actions of Nigerian thugs, and the daily course of Libyan civil wars will not attract investors to capital projects with 4 to 6 years lead time.

For the sake of the long-term health of its own economy, the US must withdraw from that system while we are still in a strong position and establish an independent stable system of oil supply and prices for itself and a select few reliable suppliers and trading partners.

The United States largely created and developed the oil business worldwide and now finds itself the world’s largest petroleum user and one of its largest producers with a marketing and pricing system subject to the whims of adversarial foreigners.  Prices are highly volatile, set by market traders based on bad data, rumors, fantasies, and conjecture.  The domestic industry is an unrecognized but potentially major geopolitical asset largely financed and regulated in New York and Washington by people isolated from, and with limited knowledge of, the industry.  We now have the largest internationally-traded commodity intertwined with a precarious international financial and banking system operating mainly to finance American debt.   This entire system is metastable and subject to forces outside US government or oil-industry control which have the potential to impact catastrophically our economy and political systems.  This situation is a result of actions taken during the Nixon Administration and the so-called “Energy Crises” of the 1970’s and their aftermath.  We again seem to be in the position of making policy based on wrong perceptions.  The United States is now a victim of a market and supply system of its own creation in the hands of adversaries – it is imperative we regain control.

Globalization has not served the American people well and they realize it.  Globalization has mainly benefited China and made it rich.  The US is confronted with 4 or 5 adversarial situations in the world and seems to directly or indirectly finance our adversaries in all of them.  This is a policy which at best can be considered shortsighted and at worst just plain stupid.

Opposing globalization, considered to be free trade with anybody and everybody, seems to be interpreted as advocating isolationism.  Not so; trade policies do not need to be 100% one or the other.  Trading partners can be chosen as reliable financial, political, and business counterparties who are not adversarial and not expected to become so.  Establishing trading blocs can be beneficial to all concerned – a form of limited globalization.

On June 29, 2017, President Trump gave a speech at the Department of Energy regarding his planned Energy Policy.  He proposed a program to achieve “Energy Dominance” in which the US would “export American energy to The World to establish Dominance”.  To a world already largely dependent on energy from Russia and Arabs with respect to supply and price determination the idea of being further dominated by the United States must not have seemed very attractive.

President Trump outlined factors by which the US would establish this dominance:

1. Expand domestic US nuclear power for electricity generation
2. Remove barriers to financing foreign coal-powered electric plants
3. Build a pipeline to export gas to Mexico
4. Sempra Energy will begin negotiations to export Liquefied Natural Gas to South Korea
5. Two applications to export LNG from Louisiana have been approved
6. Initiate a new offshore US oil and gas leasing program in areas previously closed to leasing.

A few days later, Secretary of Energy Rick Perry defined Energy Dominance:

“An energy dominant America means self-reliant. It means a secure       nation, free from the geopolitical turmoil of other nations who seek       to use energy as an economic weapon.  An energy dominant America       will export to markets around the world, increasing our global                 leadership and our influence.”

The clear emphasis by the President was on exporting “energy” but in what form was not clear.

None of the President’s six points nor the Secretary’s definition offer a clear means of establishing “Energy Dominance”, self-reliance, or freedom from geopolitical turmoil.  If Energy Dominance means self-reliance that sounds much like energy independence which has been an objective of every American President since Nixon thought he had an Energy Crisis in the 1970s.

The US is not in a position to establish Dominance by exporting coal, nuclear plants, electricity, natural gas, or oil “to the World”.

Exporting coal must contend with restrictions imposed by climate and emissions considerations.   Expansion of nuclear power for electricity generation is a worthwhile objective for many reasons: reduced emissions, increasing electricity demand, and a reduced physical footprint compared to solar and wind methods.  The rest of the world has moved forward with nuclear technology while the US has not built nuclear plants for decades, however, and the US has reduced its nuclear manufacturing capabilities.  From a weak position, the US would be entering a market already supplied.  Development of nuclear power by the US will mainly be for domestic use.

The US has developed domestic gas supplies to the point we are the only advanced industrial nation to meet the reduced emission requirements of the Kyoto treaty.  We did it by replacing coal-fired electric power plants with natural gas.  Abundant natural gas supplies were developed with a combination of horizontal drilling and hydraulic fracturing which environmentalists oppose with their own peculiar version of logic.  The Europeans also refuse to apply these technologies to develop their own gas supplies preferring to continue hand-wringing and complaining about being dependent on Mr. Putin’s sympathies.

With our large domestic supplies of natural gas and low prices for power we have stimulated investment and expansion of new manufacturing facilities in the US.  We can export natural gas or electricity to our neighbors, Canada and Mexico, and have historically done so.  Both of these countries have large domestic supplies of energy, however, so exporting to them is based on convenience of location of supply, markets, and transportation facilities and cannot be expected to establish World Energy Dominance.

Exports of US gas to other parts of the world as Liquefied Natural Gas increased significantly in 2015, mostly to Latin America, but they have not yet reached the level of a strategic commodity to achieve dominance.  These gas exports are entering a market with abundant sources of supply and with transportation routes and facilities already established.  US gas supplies are not in a first-supplier position or shortage environment to establish dominance in most of these markets.  EIA estimates that US gas exports will not exceed 10% of domestic production.   I have been through several cycles of abundance and shortage and have reservations about exporting resources we may need later.

Which brings us to oil.   Oil is the elephant in the room with respect to international financial relationships, foreign policy, supply and pricing relationships, and strategic concerns for several reasons.  First:  A reliable oil supply at tolerable cost is necessary to establish and maintain a modern economy.  Second:  Oil is the largest component of international trade.  Third:  Oil is priced and paid for in international trade in US dollars, known as Petrodollars.  This price system and the size and critical nature of the oil markets supports the US dollar as the international reserve currency, tightly intertwines the oil markets with the international financial system, and causes the value of the dollar and Federal Reserve actions to significantly impact the price of oil.  Fourth:  Many major industrialized advanced economies are large consumers of oil but have no significant indigenous supplies of oil and many nations with major supplies are not major consumers.  Therefore maintaining trade between consumers and producers is critical.  Fifth: The US imports over 8 million barrels of oil per day.  Sixth:  For all the previous reasons, oil is a major consideration in foreign policy but is understood by few people making that policy.

The US, with considerable expenditure of capital, time, effort, and other resources and over 200 oil company bankruptcies has developed and applied oil-well horizontal drilling and hydraulic fracturing methods which have significantly increased US oil production by more than 4 million b/d; this increase has been widely publicized and recognized.  In addition, US demand has decreased somewhat.

The salient point, however, is that the US still imports over 8 million b/d of oil. 

The US is not self-sufficient with respect to oil supplies.  All oil exported by the US must be replaced by increased imports.  To reach oil supply independence and develop an additional significant export capability would require the US to increase sustained production by about 3 times as much as it already did.  This is an unrealistic objective; it will not happen.

In our foreign affairs we are confronted by China, Iran, and Russia.  Each of these confrontations involves oil in some fashion and each of these countries is heavily involved in Venezuela.

Vladimir Putin has an obvious foreign policy; he is using energy to dominate Europe either directly with Russian resources or through Russian companies, particularly Rosneft, which invest in and gain control of strategic oil and gas supplies worldwide.  Rosneft is now negotiating a takeover of Venezuela’s oil fields.

Venezuela is still supplying oil to Cuba, Nicaragua, and Bolivia and supporting other Latin American socialist paradises despite the failure of its domestic economy.  This in a country where the oil industry was initially discovered and developed by American companies and which produces a relatively heavy oil which American Gulf Coast refineries were designed to process decades ago.  The US has announced it may not buy any more Venezuelan oil.  Would Rosneft sell it to us?  They have plenty of customers: China, India, etc.

So:  Who is the Dominator?   Who is the Dominatee?

Because they are so closely inter-related, the US needs clear, strategic, and realistic foreign, energy, and financial policies.  We do not need policies based on unattainable results and offensive slogans.  Who is formulating these policies and who is establishing strategy?  The domestic industry currently provides a strong position from which to establish new supply, market, finance, and price relationships.

This commentary is not directly about oil – but it concerns the location of the largest oil deposits in the world, in our own neighborhood, which we have acquiesced in allowing them to be dominated by adversaries.

In the 1990s I was doing considerable business in SE Asia and was in and out of Hong Kong frequently.  In July, 1996, I was asked to give an after dinner talk to a mixed audience in a rather rustic setting in Northern California on what I expected would “Happen to Hong Kong when China Takes it Over”.  The transfer of Hong Kong from British to Chinese rule was scheduled for the following March.

Although scheduled to arrive onsite a few days early, due to flight delays, meetings, and so on, I arrived just before dinner in a suit which I was contemplating burning if I ever got it off.  I told the audience that I thought the subject needed to be changed to:  “What will Happen to Us When Hong Kong takes over China”.  My thesis was that combining the 24-hour, 7-day-week, full-bore capitalistic, entrepreneurial energy of Hong Kong and its capital, management experience, and aggressiveness with the largest, cheapest labor force in the world would be a problem for us, not them – and they would bury us.  Many acquaintances were already moving plants and offices to Shanghai.

When asked what we should do about it, I said we should embrace Latin America; a continent with a shared history of European colonialism, Christian faith and values, and a Western Civilization heritage; a continent with a large population and rich in resources.   We should establish treaties, economic ties, and other strong relationships with the countries there.  I saw no other way we could counter China’s size in any contest for world dominance.

What have we done about Latin America?  Almost nothing; mostly we ignored it.  Although in November, 2013, Secretary of State John Kerry announced to the Organization of American States that the Monroe Doctrine of the US was no longer in effect; another foreign policy action which cannot be justified by rational analysis.   This decision was consistent with long-term policy neglect of other countries in our own hemisphere.  Many of them do not even have ambassadors.  We have increasingly antagonized, alienated, estranged, and withdrawn from, Latin America.

This neglect has been exploited by China and Iran who have been penetrating the area for many years.  Iran has expanded its diplomatic, intelligence, fund-raising, and Hezbollah presence throughout Latin America.  After Kerry’s announcement, Russia announced their intent to build naval bases in Venezuela and Nicaragua, the same countries where Iran has reportedly built missile bases.  Failure to do this yet probably has more to do with the drop of oil price than lack of intent.  Of course, Kerry’s announcement was well received by both Venezuela and Nicaragua and their Marxist dependents and allies:  Bolivia, Ecuador, and Cuba.

The attitude toward Latin America among US foreign policy commentators is obvious.  After the election several journals had special sections of commentary regarding their analysis of what foreign policy will be with the new Trump Administration.  I reviewed  and issue of Foreign Affairs which had a section titled Trump Time.  This was a special section with multiple authors with their opinions regarding various subjects which they considered challenges facing the new Trump Administration and discussions of various aspects of foreign policy.  Similar reviews and analyses appeared in other journals as well.   I presume the discussions pertain to the issues considered of primary importance by the editors and the authors.  Latin America is not mentioned; it is the Missing Continent.

We ignore Latin America at our peril.  We maintain armies in the Middle East and Central Asia and have an uncertain supply and volatile price of oil when the largest oil deposits in the world are in Venezuela, a country falling apart, and Colombia, a long-term friend, and we offer no help.   We need to strengthen our bonds with these countries in particular and Latin America in general.

Venezuelan Agonistes

Venezuela is in terrible shape.  The social/economic situation there is so bad the New York Times and other mainstream media, never eager to point out the failures of Socialism, have taken notice.  The country with the largest oil deposits in the world cannot feed its own people.  Even the Organization of American States, one of the most lethargic of international organizations, is criticizing Venezuelan government policies.  The oil industry is so mis-managed it is importing oil from the US for its refineries.  The government is supplying oil and propping up its Communist brethren in Cuba and Nicaragua while a generation of its own children will be stunted by malnourishment.  Russian, Iranian, and Chinese influence and presence in the country are growing less than a five-hour flight (or a medium missile range) from the US.

What are we doing about it?  We are still buying between nearly 800,000 barrels of oil per day from Venezuela and following a common US foreign policy practice: Trade with our adversaries and make them rich.   We send troops and aid missions around the far corners of the earth on so-called humanitarian missions but ignore a true humanitarian problem of a long-standing friend in our own neighborhood.  Is the problem that we do not want to publicize the latest blatant case of the failure of Socialism?  Venezuela is a great candidate for a Case Study of how Socialism can wreck a rich and prosperous economy in less than 20 years.

What can we do about it?  Headlines today say the Trump Administration is considering sanctions.  These seem to include cutting off purchases of Venezuelan oil by American companies.  Cutting off income to the Venezuelans is not a policy which will accomplish much for the starving population.  It probably will not be successful because the Chinese will then buy the oil anyway.

We need to find a policy that will get some direct help to Venezuelans.  I think we should try Wal-Mart.  CITGO is an American oil company owned by Venezuela which is in debt to the Russians (Rosneft) and the Russians are considering foreclosure and then would control the company.   The US should impound its assets and payments by American companies for Venezuelan oil and put them in an account in trust for the Venezuelan people.  These funds can then be accessed on-line by individual Venezuelans who can go to a computer terminal, enter their ID number and make a withdrawal every two weeks.  For those without access to the internet, terminals can be set up at Wal Mart facilities.  The withdrawals can be in the form of a currency or pre-paid credit cards redeemable at Wal-Mart for food and daily hygiene items.  The currency and cards would expire in six weeks to reduce value to criminals.  Redemptions of the currency or cards would be covered from the Trust Account.

A lot of details will need worked out: The computer systems, the logistics, and security.  I have every confidence that this country has the ability to put the right people together in a room – and I know some of such people – and the details can be worked out in less than 48 hours.  We could then start moving food and soap and toothpaste to our suffering neighbors – if not with Wal-Mart, then by another means; we need to help them.

Last winter I had an exchange of correspondence with a group in Washington hoping to have some influence on the new Trump Administration regarding foreign policy, oil supplies, interlinks between the international oil and financial markets, and financial policy.  As some of you know, I also gave a speech on those subjects with the general theme of “Where are We?, How Did We Get Here?, and What Can We Do About It?”  Those efforts got sidetracked by delays making appointments to the various departments, the noise over Russian influence on the election, Comey, and other Democratic obstructionism.

During the last few weeks Trump made a trip to Saudi Arabia, gave a speech regarding exporting energy last week, and has rescinded regulations pertaining to energy, approved pipelines, and announced various policy considerations regarding energy and international supplies. My communications with friends in Washington resumed.  These have evolved into a series of analyses on various subjects regarding the oil business and foreign policy.

This is the Fourth of July, so I decided to share these opinions and analyses with you for whatever interest you have or value you get from them.  This may be a series at irregular intervals.  If you wish not to receive them, just let me know.  Your comments, suggestions, and additions are welcome.

My considerations are focused on the oil business because it is the business I am in, it is the largest internationally-traded commodity, and international oil trading priced in dollars maintains the dollar as the international reserve currency and intertwines the international oil and financial markets.

These considerations are also influenced by my experience during what might be called the Decade of Confusion: 1973 to 1983, in which the United States exchanged an oil price and supply system dominated by the international US oil companies and a dollar backed by gold for a system dominated by foreign governments, a dollar backed by other countries’ oil, and the price determined on an open exchange.

During that period it seems no one in the US Government understood the industry.  The US Government, and many others, reacted strongly to two Energy Crises which did not exist.  Many policies were initiated based on the belief that the United States was threatened with a shortage of oil. In fact, no oil shortage ever existed during the entire decade of turmoil from 1973 to 1983.  Exactly the opposite was true, the international oil industry had approximately a 12% surplus production capacity in 1973, developed many new fields and sources of supply in response to the oil price increases and by 1983 had approximately a 30% surplus capacity.  Once oil started trading on an open market and the surplus capacity was widely recognized the price fell precipitously in 1986.

The Petrodollar was born in 1974.  Kissinger negotiated an end to the Saudi Oil Embargo imposed during the Yom Kippur War.  He renewed Roosevelt’s World War II US guarantee of Saudi security.  The Saudis agreed to sell oil only for US dollars.  Other producers followed suit; the dollars used in the international oil markets became known as Petrodollars.  The Petrodollar still exists.  Oil is still priced and bought and sold in international markets in US dollars.  All purchasers of oil must have had a supply of dollars from 1974 until now.

The perceived shortage of oil by the US government and public caused a sense of vulnerability in the US which led to many policies which are still in effect and a belief that only through globalization would the US have access to the resources it needed from other countries. The US, long a mostly self-sufficient economy thus embarked on a path of global involvement which is now being questioned critically; we are in a transformation period politically, economically, and socially.

Creating the Petrodollar allowed the US to incur significant debt for social programs which in effect have been financed by the international community.  As US Government debt increased significantly during the past two administrations considerable resentment developed regarding the dollar as the international reserve currency.  Several countries have expressed intentions to establish a successor to the US dollar, so far without success although some one-on-one transactions use other currencies, e.g.: China buys Russian oil and pays in yuan.  As the Saudis tried to increase their market share in exports to Asia, China attempted to establish the trade in yuan; unsuccessfully for the time being.   An effective alternative to the dollar has not been found – but at some point, one may be; which is an ongoing threat to the US economy.

The US dollar welds the international oil markets intimately to the financial system.  The oil price reflects changes in the strength of the dollar and Federal Reserve policies.

In July 2008, market perceptions of impending supply shortages spiked the oil price over $147 per barrel.  As the financial crisis developed, the price dropped below $30 in early 2009 and then recovered to approximately $75 per barrel.  The Federal Reserve started injecting dollars into the financial system on November 3, 2010 with the program called Quantitative Easing 2.  The Saudis announced they would respond with a $25 increase in the price of oil.  Oil traded in a range around $100 until August 2014 at which time the Federal Reserve stopped the Quantitative Easing program.  The oil price started declining and had dropped to about $75 by late November.  At that time, the Saudis announced they would not support the $75 price and the price continued to decline to the $50 range in early 2015 and to the $30 range in January 2016.

The critical point, not widely recognized, is that the price of oil started its decline when the Federal Reserve ended Quantitative Easing, not because of excess supply as commonly reported.  Unusual storage increases did not start until early 2015 when the price had already dropped to the $50 range.

Trump pulled a real coup with his trip to Saudi Arabia.  His warm personal welcome by the King and his blatant re-assertion of close ties with the Saudis indicate that threats to the Petrodollar have been deflected.  The US can expect the US dollar will be the currency used for most oil trading for several more years and the dollar will remain the international reserve currency.  This is a major benefit from his visit but was not reported anywhere in the press that I saw.

2016 was a year of reports of disappearing oil which then seemed to mysteriously reappear.  Headlines such as “Huge Decline in US Proved Oil and Gas Reserves”, “US Producer’s Oil Reserves Plunged 12% in 2015”, “World Oil Reserves Stable Despite Drop in Investment – BP” were typical, implying a crisis – or not, depending on your reaction to them.  Mainly they revealed a lack of understanding of “Reserves”, what they are and how they are determined by “analysts”, financial institutions, and newsletter headline writers.

In the course of discovering and developing an oil field the first estimate of the amount of oil in an exploration target is by geologists and geophysicists who have studied the area and identified the target.   They estimate the amount of oil which has formed in an area and the amount collected in a reservoir.  Engineers become involved to plan the development and production of the field and they forecast development schedules, costs for development and operation, production rates, and revenues.  These forecasts result in estimates of the amount of oil to be recovered from the reservoir.  These are technical forecasts and an important management tool.

Converting these technical forecasts of future production to Reserves and Present Values estimates are an accounting and regulatory activity.  Reserve estimates and their Present Value are required by regulatory agencies in a few oil-producing countries for companies with stock that trades on stock exchanges.  Regulatory agencies establish rules for determining these reserves, calculating their Present Value, and accounting for them and their costs on financial statements.  These jurisdictions and the regulatory agencies are primarily the US (Security and Exchange Commission, Financial Accounting Standards Board), Canada (Toronto Stock Exchange), and the UK (Petroleum Reserves Management System, Financial Reporting Commission).  These three jurisdictions do not have uniform rules and regulations.  Therefore, the same forecast can have considerably different Reserves and Present Values estimates in different jurisdictions and be accounted for differently.  I once had the responsibility to report in all three jurisdictions for a property in Texas; with one engineering forecast, the Reserves varied over a range of 80% because of the different reporting rules.

Regulated Reserves and Present Values reported estimates cover about 10% of the world’s oil resources and 15% of its oil production.  The rest of the world’s oil is owned by governments and organizations who have no interest in reporting their reserves or in telling the truth.

Reserves for companies with shares traded on US stock exchanges are generally considered oil that can be recovered under current economic and operating conditions as defined by the SEC.  US reported Reserves fall into two main categories: Proved Developed Producing (PDP) which is the amount of future production from wells already drilled and Proved Undeveloped (PUD) which is the future production from undrilled locations in close proximity to existing wells where wells will be drilled within the next 5 years.  The Present Value of future production is the net income from the future production discounted at 10% per year (PV10).  Reserves and their PV10 values are reported on SEC Form 10-K each year.

I reviewed the 10-K filings for 17 companies active in developing “unconventional” resources to ascertain the effect of the decrease in price on reserves.  For these companies, Reserve reductions due to the price drop are in the range of 10% to 50%; most of the companies are between 10% and 30%.  It was interesting to note that the Reserve decrease is between 30% and 50% for companies that had declared bankruptcy.  For PV10 values, the decrease due to the oil price drop for most of the companies is between 90% and 120%; for companies which had declared bankruptcy, the decrease is less than 75% – a reverse of the expected result.  Decreases of Reserves and PV10 were mostly in the PUD category.   A large part of that is probably due to budget cuts which reduced the number of wells to be drilled within the next 5 years.

These disappearing Reserves quickly reappeared, however.  Programs of infill drilling, expanded fracturing programs, re-fracturing of existing wells, completing wells in new zones, drilling new laterals in older wells, improving production rates from new wells, and acquiring new assets quickly replaced the Reserves lost due to the price drop.

Never doubt the resilience of the American oil industry.

The major point to be realized is that the Reserve reductions due to the price drop are because of accounting and regulatory rules and, although the underlying forecasts may have been modified as to schedule and revenues, the oil did not disappear; it is still there.  Also, the Reserves that replaced the reductions are, in many cases, not the same oil but oil that due to certain actions can be added to Reserves for the first time as new technology and efficiencies increase recoveries.

Therefore, headlines that indicate US Reserves have decreased by 11% or 12% when the oil price drops by more than half are misleading when they characterize such drops as “huge” or a “plunge” and implying these decreases are alarming.  They are not; in fact, such small drops under those conditions show the strength of the industry.  The oil is still there and the reductions are only due to accounting rules.

As noted above, most of the world’s resources are not subject to regulated reporting requirements and therefore world Reserve figures are not modified due to changed economic or operating conditions.  They generally are changed only to reflect new discoveries and are inflated for political purposes.  For instance, Saudi Arabia has had 260 billion barrels of reserves for about 30 years.  During that time it has produced about 75 billion barrels and the economics of the industry have changed dramatically but nevertheless Saudi Reserves remain at 260 billion barrels.  This is known in the industry as due to a Magic Source Rock, a geologic phenomenon which creates new oil at exactly the same rate as the rate of production, year after year.  A headline that indicates that World Reserves remain stable despite a drop of investment is meaningless.

This is the rainy season in much of the tropical portion of the Western Hemisphere and after a frantic and busy day in a major oil-producing country I have enjoyed a candlelight and wine dinner under a palapa in a major downpour.  This is in an environment characterized by fifty shades of green with brightly colored blossoms and birds but the major feature now is rain as only the tropics can provide:  Lightning, thunder, and water as if it is coming down from a firehose; strong, warm, and unremitting.

The oil news today is much like that of the last several months. Conflicting commentary and speculation as the the size and nature of The Glut. Minor and questionable data are subjected to microscopic analysis to determine:  Are we post-peak Glut yet? Where is The Glut?  When will the oil price go back up?

The first thing noticeable about this Glut is that it is so small. Perhaps that is why it is so hard to find, describe, and analyze. Most estimates of worldwide production overcapacity last year were in the range of 1.4 to 1.8 million barrels per day – in a market of about 95 million barrels per day – or about 1.5% at its peak. We seem now to be in a post-Peak-Glut situation but no one is sure. I am skeptical the data are accurate within 1.5% so trying to find and describe such a mini-glut with such data seems futile.

General commentary regarding The Glut seems to have recognized the production capacity glut was small and is getting smaller to the point of disappearing. Glut concerns have now shifted to the amount of oil in storage. Concerns about The Storage Glut are somewhat frustrated by the fact that we do not know how much oil is in storage. A second concern is the amount of storage used for crude oil and the amount used for refined products. OECD countries report storage volumes, with some accuracy, but Russia, China, third-world countries, and various oil-trading organizations see no reason to report how much oil or refined products they have in storage or where and many reasons not to – and they have more than half the world’s stored oil.

So the oil market is in a volatile situation in which reported small changes of production rates and storage volumes have exaggerated effects on quoted oil prices. Some of those reports, not many but some, may be accurate but the market is also responding to rumors, lies, errors, hallucinations, and wishful thinking. The usual suspects are blamed for this situation: Rupert Murdoch, the Koch Brothers, Jews, Big Oil in the form of Exxon Mobil, bankers, frackers, and Greenhouse Gases.

An odd aspect of the current Storage Glut is that even with large surplus storage, imports to the US are increasing.  Something does not add up; not unusual in this market.

The current oil price downturn is associated with the smallest production overcapacity of any downturn since the Second World War.  The fact that it was triggered by the end of Quantitative Easing by the Federal Reserve and then stimulated by the Saudi decision to maintain market share can explain the large price effects of a mini-glut.  Small variations of supply and demand can cause extreme market price variations in marginal pricing systems with small contract sizes.  Likewise, once demand equals production capacity through either demand growth or production decline a large increase of price can be expected quickly as we swing to production undercapacity and buyers bid the price up.

No other commodity is so involved with geopolitics or so intertwined with the financial markets as oil.  To expect clarity with respect to reporting of strategic information is unrealistic.  Therefore we must make do with what we have and marinate that with experience and that indicates that the oil price will be volatile as supply and demand are roughly in balance but as demand increases and supply declines we can expect upward pressure on prices.  The suddenness of the price rise will be somewhat tempered as excess storage is drawn down over an extended period; owners of stored oil will not want to sell too soon – they will wait to take advantage of as much price increase as they can.  When they think the rate of increase is less than the storage cost, they will sell – gradually so as not to kill their own market.

As I start this posting the WTI NYMEX Oil Price has just gone through $49 per barrel on a general trend upwards.  This is an increase from a bottom of $26 and change in February.  This upward trend is concurrent with increasing strength of the dollar which supposedly causes decreasing oil prices.  This upward trend is also contrary to general predictions on Wall Street (e.g.:  Goldman Sachs) that oil prices will drop to around $20 (some are predicting $10) but it is also in compliance with many other predictions that an increase back to more than $100 can be expected by the end of the year.

Daily headlines regarding the oil supply – demand balance and the effects on oil price also are conflicting.  We can read on a single day that “Oil price is down due to a stronger dollar”, “Oil price is up due to significant lost barrels”, “Oil price is down due to a storage build” (of 1.3 million barrels), “Oil price is up due to strong demand from India”, “Oil price down due to return of Canadian oil sand production”, and “Oil price down as Fed signals interest rate increase in June”.  Other influences are that Iran, Alberta, and Iraq are increasing production while Nigeria and Venezuela are decreasing production and Libya is predicted to decrease and increase depending on whose prediction you read.

All these conflicting influences and predictions indicate an oil market and pricing environment which is not well understood, buffeted by a myriad of influences, and very sensitive to all of them.  This confusion is the result of a oil price downturn like none of its predecessors, subject to forces and influences not present in previous downturns and therefore responding to those forces and influences in unanticipated ways.

This downturn is taking place in an international financing, banking, economic, and geopolitical environment which, despite wishful thinking and pronouncements from the Obama administration, has never recovered from the 2008-9 financial crisis.  At this time, we have a fragile banking system with low reserves in a chaotic and unstable high-risk environment.  Europe has never recovered and has compounded its problems with immigration crises, uneconomical energy decisions, and increasing pension and union labor burdens.  Investors are pulling out of European markets.

In the US, we have a Federal Reserve Chairman who, within 30 minutes testified to Congress that she was very surprised by changes in the oil price (which she had a large influence on) and was taken off-guard by the drop in the value of the dollar (management of the value of the dollar is a responsibility of the Fed).  High officials in the IRS admit to corrupt and unlawful practices but the Treasury and Justice Departments take no action.  Such public admissions of incompetence and corruption do not instill confidence in investors with respect to our banking, finance, and legal systems.

At the same time, the head of the IMF, Christine LaGarde, is advocating that banks in the major economic countries alleviate government debt problems by confiscating 10% of the deposits in their banks.  Of course, she does not call it confiscation; for the funds confiscated she proposes awarding shares in the same bank that has been so mismanaged it must confiscate depositors’ funds.  In addition, she advocates negative interest rates, which is an incremental form of deposit confiscation already in practice in some European countries and Japan.  Negative interest rates were also mentioned as a possible policy by our own Federal Reserve Chairman in a speech in which she also suggested the Fed would be increasing interest rates at some time in 2016.

What the Fed Chairman does not seem to realize is that in response to the vote to approve Quantitative Easing 2 (QE2) in late 2010 the oil price increased and in response to the end of Quantitative Easing in August 2014 the oil price started a long slow decrease.

Many commentators blame the oil price decrease on storage increases and refer to the increased production capacity and storage as a “glut” but storage increases did not start until early 2015 and the surplus production capacity is variously estimated as between 1.3 and 1.8 million bbls/day – in a 95 million bbls/day market – or about 1.5%.  This is certainly the smallest glut to ever cause an oil price crash and industry downturn.

In August 1971 President Nixon cancelled the convertibility of the United States dollar to gold; the dollar started a long decline in value and has lost approximately 95% of its value from then until now.  In October 1973, the United States supported and supplied Israel in a war with Egypt and Syria.  In retaliation, Saudi Arabia declared an embargo of oil shipments to the United States (and Holland, and later South Africa).   US Government agencies and the American public presumed this action reduced oil available to the US (it did not) and everybody tried to fill their car gas tanks at once causing gas lines and a panic about fuel shortages.

Secretary of State Henry Kissinger, about the only functioning part of the United States Government who was not caught up in the Watergate scandal, flew to Saudi Arabia and met with the Saudi King.  He renewed the US guarantee of Saudi security (first provided by Franklin Roosevelt during WWII) on the condition that the Saudis would sell their oil only for US dollars.  The Saudis agreed but, because the US dollar had been de-linked to gold, they would increase the price of the oil from about $2.50 per barrel to $15.  In addition, two years later they nationalized the US companies out of Aramco and renamed it Saudi Aramco.   Thus, the Petrodollar was born.  Nixon resigned.  A decade followed of Arab domination and turmoil in the oil markets.  Other Arab countries followed suit and eventually the US dollar was used for all international oil trading and the US dollar is the world’s reserve currency to this day – but it is under attack and may not be for long..

Lately, various countries have started trading oil in other currencies, notably China and Russia.  Iran is also trying to trade oil in Euros.  With a sustained attack on the Petrodollar and a weak US Administration, the dollar may lose its status as the world’s reserve currency in which case, with high US Government debt and a weak bank system, it can be expected to lose value precipitously.

With a weakened and vulnerable banking system which may be used by governments to confiscate deposits to pay down government debt and attacks on the dollar the question arises as to what one should do to protect wealth.  Where can you park your money?  Many suggestions are offered for investor consideration:    Farmland, gold, silver, pallets of AK-47 and AR-15 ammunition, diamonds, art, and others.  These all may be of interest for individual investors up to a certain value but for storage of wealth in the range of several billions of dollars some of these are not practical.  What possibilities are available for fund managers moving out of equity and bond markets looking for places to put wealth where it can be maintained and have a reasonable return?

An interesting study by Ramon Marimon, Ellen McGrattan, and Thomas Sargent (Journal of Economic Dynamics and Control 14 (1990) 329-373) found that in a market actively trading many goods and commodities the medium of exchange will become the commodity with the lowest storage value.  For centuries that medium has been metals, usually in the form of small metal discs.  But when one considers the preservation of value of billions of dollars the transport and storage of metal discs (or bars) becomes awkward and impractical and the storage cost may not be so small.  In addition, low storage cost may be necessary but it is not sufficient.

A medium of exchange must also:

1. Be of a recognized and certified character and quality.  This was achieved with small metal discs by stamping images of kings or emperors on one side and a coat of arms or religious symbol on the other.  The US tends to put an image of Miss Liberty on one side and an eagle on the other.
2. The medium must be available in sufficient quantity to provide liquidity in the markets where it becomes the medium of exchange.  This rules out such things as the Swiss Franc for the international markets.
3. The medium must have widespread acceptability and be politically neutral.  The dollar’s status as  the world’s reserve currency is still justified and supported by its status as the Petrodollar but this         status is under attack from external parties (China, Russia, and Iran) and is in doubt because the Obama administration has scuttled the US-Saudi relationship.

In addition, widespread acceptability and political neutrality of the dollar has been systematically undermined by domestic policies for several years.  Quantitative Easing, Dodd-Frank, IRS and DOJ corruption, banking system instability, imposition of US politics on foreigners, and FATCA have undermined the value, stability, neutrality and desirability of the dollar and banking relationships of foreigners with the US.  Many foreign individuals, banks, companies, and other organizations now avoid business with the US unless they need dollars to trade in oil.  Because of this, if the status of the Petrodollar erodes, dollar value in international transactions will collapse.

Because of the current weakness, instability, and low returns in the traditional bond and equity markets and the banking system, oil has several advantages for storing and investing wealth:

1. It is one of the largest and most fungible commodities in international trade. Its trade is large enough to provide liquidity in the international trading system.
2. Because an adequate oil supply is necessary to maintain any modern economy, oil has a liquid market and will for decades to come.
3. Oil is fungible in the currency markets; it can be traded directly or exchanged into any other currency – now or after any major            upheavals in the international monetary                                               system and re-alignment of the world’s currency markets after either dollar or Euro collapse.
4. Oil is traded on open markets and public exchanges with open pricing, and
5. The quality and quantity of oil trades are certifiable in a widely recognized and accepted format by international agencies, shipping companies, terminal operators, transport operators. and other third parties.
6. The oil markets are closely interrelated with the financial markets.

Storage of a barrel of oil generally costs between $0.25/bbl/mo and $0.50/bbl/mo or, at today’s oil price, between 5% and 10% per year.  Thus, buying oil and storing it makes sense as an investment if one believes the return is higher and safer than can be obtained by keeping money in a bank or investing it in a bond market.  With a production overcapacity of about 1.5 million bbls/day in a 95-million-barrel-per-day market, overcapacity is only about 1.5% – pretty thin, so once that disappears, a rapid increase in oil price can be expected.  Volatility is a hallmark of marginal prices determined by open bidding in public markets so a rapid increase of oil price can be expected for a small variation of the demand/supply balance.

The question then becomes:  Where else could you invest funds and get a better return in the next three years than in buying oil and storing it?   As an investor or as a refiner.

The oil downturn and drop in oil prices since August 2014 is commonly attributed to surplus production capacity compared to demand and large increases of stored oil in various parts of the world – commonly described as a “glut”.  As noted above, however, oil prices started downward in August, 2014 with the end of Quantitative Easing by the Federal Reserve.  Increases of storage above normal levels did not occur until several months later in early 2015.  Reports of tankers full of oil standing in various ports of the world and above-normal storage of oil in various land terminals and storage sites have persisted ever since.  Additional storage facilities have been built. Crude oil storage in the US is above normal by about 40%.   The downturn in prices did not result in widespread production shut-in, however.  Somebody is taking advantage of low prices and buying the surplus oil and storing it.  That buying is putting upward pressure on prices.

As I post this, the WTI NYMEX oil price is still above $49/bbl.