The Oil Ambush

You didn’t see it coming. The danger seemed to recede. You let your defenses down and breathed a sigh of relief. But youwere wrong, and by the time it was on you, it was too late.The danger had been there all along. You walked straight into an ambush.  The Islamic State in Paris last week, combined with the December 2014 oil price dive leads many to view Oil Dependence as the least of our worries. They would be wrong.  We are in the midst of an Oil Ambush. Expensive oil will follow cheap and the link to terror bodes ominously for us all.

Oil, the world’s most traded commodity, is unique. Sitting at the nexus of geopolitics and money, oil can, like no other commodity, make and break global power structures.

The Oil Ambush – the way prices entrap us- has had a recurring script, ever since 1973. The OPEC oil cartel collectively owns the largest and cheapest-to-extract oil reserves and is the key influence on global oil prices.

Typically, OPEC kicks off the Oil Ambush by keeping oil production constant in the face of falling demand.

Oversupply reduces prices, knocking OPEC competitors who need expensive oil to stay afloat.

The damage done, OPEC hikes prices again. The result: OPEC wins power and profits.

The Oil Ambush is now on us- as I’ll shortly explain, the 2014 oil price drop of 50% must be followed by a price rise. But this Oil Ambush is different. Why?

Firstly, on this occasion, the Saudis strong-armed the cartel to reduce prices. They could do that as the leaders of OPEC (thanks to vast Saudi oil reserves and cheap extraction costs). Despite the Saudi claim that $20 / barrel oil suits OPEC, there is angry dissent from Iran. OPEC’s second most powerful member labels cheap oil a Saudi “political” initiative.

Secondly, this Oil Ambush- as I’ll discuss- seems motivated by Saudi strategic concerns. That contrasts to past ambushes that were often OPEC market, politic or profit grabs.

Top of the list of Saudi strategic concerns is Iran. Sunni Saudis and Shia Iran are not friends. Iran is a direct threat, and “nearly nuclear”. The economy is its weak spot. Constrained by sanctions and cash poor, it needs oil at ~$150 / barrel to balance its budget. Cheaper oil severely weakens Iran.

Da’ish (Islamic State), the world’s richest terrorist group, deeply concerns the Saudis. Da’ish sells captured oil at below-market prices. Reportedly, they earned up to $3 million daily when oil prices were $95. Cheap oil throws a spanner in Da’ish’s works.

 

Russian President Putin’s steadfast support for Assad in Syria irks the Saudis. Thanks to Western sanctions, Russia isn’t in great financial shape and the 2015 budget assumed Russian oil sales would average ~$100/barrel. Today’s $50 oil is bad news for Russia’s economy and currency.

Despite cheaper motoring, low oil prices do not necessarily benefit the West. In fact, they raise concerns. What will happen if President Putin offsets his oil losses by raising the price of gas exported to his captive European market? How will the US “tight oil” industry  (which uses techniques like fracking) survive, when it needs oil at $50-70 /barrel to break-even?

Noting the shared strategic interests of the Saudis and the West (particularly the US), some speculate the US and Saudis agreed to reduce oil prices. That may point to an increasing trend of Mideast tensions playing out via oil prices. After all, Western concern about Da’ish /Iran coincides with a reluctance to take deep military action. Economic damages due to cheap oil surely undercut potential military costs.

 

It’s also plausible that the US totally opposes cheap oil. If so, the world’s Number Two oil producer was seemingly impotent against OPEC’s decision to quickly lower prices. Could OPEC market power be greater than realized? The true test will be when the cartel tries to increase oil prices again.

And rise, prices must.

Reflect on Saudi Arabia’s financial constraints. The Saudis cover government and household spending (to top $380 billion in 2015) via oil sales. But oil prices under $100/ barrel force them to dip into their cash. Though the Saudis have the world’s largest cash reserves (~$750 billion) it won’t last forever. Four years, at most. Thus, the Saudis will have to increase oil prices again.

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In any case, in the bigger picture, the motive and mastermind behind the 2014 Oil Ambush is less relevant than the impact of many Oil Ambushes, over time. Oil that is cheap, then expensive, then cheap reinforces Oil Dependence and destroys efforts to come off it.

Consider the “rebound effect”. When oil is cheaper, so is travel. Infrastructure expands, allowing greater travel, which increases oil use. It’s too late to put the genie back in the bottle.

Aviation is a good example. Expensive oil in the 1970s triggered the industry to innovate aircraft that fly further, on less fuel. The cheap oil phase took affordable air travel to the masses. Aviation’s US scorecard: fuel efficiency up 40%; fuel use up 150%.

The cyclical Oil Ambush also (cyclically) destroys Oil Independence efforts.

 

Expensive oil motivates funding of Oil Alternatives research. When oil cheapens, Oil Alternatives fall off the government’s radar, resulting in inadequate funding. Top scientists transfer to other fields.

The Oil Ambush also attacks Oil Alternative startups and companies. Price volatility makes for volatile revenues and company valuations. No wonder investors and customers get cold feet.

Even long-successful policies are vulnerable to temporary oil price dips. In 1986, after 17 years of consistent policy, 75% of Brazilian cars were ethanol-only. But a 50% oil price drop (1984-8) was all it took to send motorists back to gasoline. (Later, oil prices went up again).

So, cyclical Oil Ambushes weaken Oil Independence research, companies and policies.

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And now, the Oil Ambush is back.

Expensive oil will follow cheap oil. History proves that expensive oil increases global instability, living costs and food prices.  Dramatic price hikes can even trigger global recessions.

Waiting for expensive oil before we re-intensify efforts will be too late.

Moreover- expensive oil will embolden Iran, Da’ish and Russia.  Should Iran or Da’iesh control OPEC or the world’s most strategic oil, the world will be in a dark place.

In an Oil Independent universe- the oil price, who controls it and MidEast shenanigans –would all be irrelevant. But they are all-too relevant. Because- as I discussed in my last article, the world is Oil Dependent.

We have neither time nor grace. We are in the Oil Ambush.

Don’t be fooled by cheap oil. The need to come off oil is more urgent than ever.

I welcome your comments and look forward to continuing this dialogue.