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.