Month: October 2017

The American oil and gas industry combines the use of massive capital, cutting-edge technology, entrepreneurial audacity, international economics, and geopolitics like no other.  Corporate strategy is a daily fact of life.  Companies which mostly operate domestically have increased US production by over 4 ½ million barrels per day.  This has been a boon to the US economy by reducing imports and the flow of dollars out of the country.  This production increase was an economic and political surprise and has become a de-stabilizing force in the international oil markets.  US companies which operate internationally are responsible for most new discoveries, increases of production worldwide, and most of the technological improvements which lead to growth in the industry everywhere.  US oil companies thus have a significant impact on the world’s oil supplies, markets, and prices and, due to the size and critical nature of the oil markets, also on international geopolitics and geo-economics.

But who is taking advantage of the current situation and taking action to improve their control and influence in the international oil supply and financial systems?  Recent news items since my last commentary provide the answer:

http://oilprice.com/Geopolitics/International/Why-Russia-Is-Playing-All-Sides-In-The-Middle-East.html

https://www.bloomberg.com/news/articles/2017-10-05/saudi-king-seeks-oil-pact-extension-on-epochal-russia-visit

http://oilprice.com/Latest-Energy-News/World-News/Russia-Morocco-Sign-String-Of-Energy-And-Military-Deals.html

http://oilprice.com/Energy/Natural-Gas/Russia-Gets-Foothold-In-The-Worlds-Hottest-NatGas-Discovery.html

Russia making deals in Egypt, Morocco, Libya, Saudi Arabia, Jordan, Turkey, Argentina, and Israel, all former allies of the US except Libya.  Is there a pattern here?  Obviously Mr. Putin has a strategy and his companies and government agents are carrying it out.  US foreign policy seems to be adrift, however, with no defining strategy or coordinating oversight.  Each component of policy seems determined and implemented in isolation with no knowledge or consideration of its influence on a broad strategic program.

The Federal Reserve oversees the banking industry.  As noted in previous commentaries, their actions starting and stopping Quantitative Easing caused significant oil price increases and decreases; for example, the significant oil price drop in late 2014 started when Quantitative Easing was stopped by the Fed in August 2014.  Saudi Arabia did not announce they would maintain market share until the end of November and increases of storage started in first quarter 2015.  An earlier commentary also included an inverse correlation between oil price and the value of the dollar.

In March 2015 the Fed Chairman testified to Congress that she was surprised by the change in the price of oil and about 30 minutes later that she was also surprised by the change of the strength of the dollar – interrelated results of actions taken by the Fed.  The real surprise was to learn the Federal Reserve Chairman did not realize the Fed’s actions affect the international value of the dollar and the oil price.

In a country which still depends on imports for about a third of its oil needs, Treasury officials recommended selling off half the Strategic Petroleum Reserve over a period of several years to raise money for the general fund of the country; an idea which may make sense from a short-term budget viewpoint but not strategically for long-term security in a dangerous and changing world.

After the end of the Cold War the US, Europe, and international institutions seemed to embrace globalization as the means to bring prosperity and equality to the world’s peoples.  Twenty-five years later it has become apparent that such a world will not be achieved by bringing 6 billion of the world’s poor up to the standard of living of the world’s rich nations.  Equality will be achieved only by bringing everyone to the mean, which is quite low; the most prosperous societies must come down in status and wealth significantly.

This result of globalization became apparent to middle class American voters as they saw their prosperity, culture, security, and well-being eroded for an ideological objective.  The US, with Europe, slowly sacrificed the prosperity of its middle class on the altar of equality domestically and internationally.  The US has supported the phenomenal growth of China, fought fruitless wars on the other side of the world in an inconsistent fashion, and tried to convert Arabs into Jeffersonian democrats.  American voters elected the only candidate, with all his quirks, shortcomings, and idiosyncracies they thought had any chance of stopping all this.

Rejecting open unrestricted globalization as a foreign policy does not mean turning to isolationism; it does mean establishing a strategy for re-establishing and enhancing United States prosperity and security for its citizens and using trade selectively as a strategic tool.

A national strategy should direct and advise the integrated use of resources to generate wealth and the judicious and cautious use of power.  By wealth I do not mean rich; rich is having a lot of money.  Wealth is reliably having what you need when you need it.  In a dangerous world, it is sometimes necessary for a government to take forceful action to safeguard the safety and security of its citizens.  The power to do that should be used rarely and carefully but it must be available as needed.  This means the resources needed may be indigenous to the nation or externally acquired but they must be reliably accessible in a useful form on demand.   Any reduction of ready accessibility for short-term financial benefit must be avoided.

A purpose of these commentaries is to point out that during the Energy Crisis Decade of Confusion from 1973 to 1983 many us policy choices were based on lack of understanding of the oil industry and oil markets.  Many of those policies were disruptive and counterproductive and we still live with some of them.  During this current period of transition of international political, economic, financial, and energy systems we are in danger of making the same mistakes based on lack of understanding of the current oil market and price system and its interconnection with the international financial system.

The United States is a large oil producer but does not produce enough for its own needs.  Currently it imports oil purchased in a worldwide fungible market with marginal pricing quoted on open exchanges.  A significant part of that worldwide oil market and supply system is in unstable regions; it is affected by myriad participants, events, confrontational politics, and ongoing wars.  Prices reflect these events and various rumors, fantasies, bad data, and perceptions of impending shortages or surpluses.  The market and pricing are volatile and not conducive to the long-term capital requirements necessary to develop new oil supplies. Oil supplies are adequate but are not reliable with respect to either availability or price.

As a large and critical resource, oil must be considered when formulating strategy and foreign policy.  Those who make and guide US foreign policy and financial policy have the opportunity to take advantage of the unexpected strength of the American oil industry but do not seem interested in doing so.   US oil companies could be powerful tools of financial and foreign policy – and have been in the past – if their activities were conducted with any coordination as part of an overall strategy of the US Government.  They have established an unexpected advantageous position for the US in geopolitics and geoeconomics but other countries are taking advantage of it.  As an example, it is noted that large gas fields discovered in the Mediterranean offshore Israel were discovered by American companies but Russian companies are negotiating with the Israelis and likely will control the transportation of this gas to Europe.  Other countries coordinate their oil companies’ activities with government actions for strategic benefit.  Our significant competitors are using their companies to establish dominating presences in many of the oil producing areas of the world.

The US needs a new reliable and stable oil supply and market system. The United States must develop a new foreign policy which is a part of an overall set of guiding principles for the government to operate in a troublesome and uncertain world.  Individual policy components, political, military, financial, economic, and foreign, must be guided by people with an understanding of that for which they are forming policy, how it fits with other policy components, and coordinated into an overall national strategy. The national government must have a strategy overarching all these policy and strategic components.  The recent increase of US oil production and its effects in international markets puts the US in a strong position to do so; it can re-align its international relationships politically, financially, and economically from a position of strength and confidence.

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.