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the last few weeks Trump made a trip to Saudi Arabia, gave a speech regarding exporting energy last week, and has rescinded regulations pertaining to energy, approved pipelines, and announced various policy considerations regarding energy and international supplies.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.