The Oil Weapon is Wielded


–What resilience! Markets took less than 24 hours to shake off the spectre of a sovereign-debt default by the United States government. Most of the major indexes finished up on Tuesday trading. The spot gold price is just dying to close over US$1,500. And even oil got in on the act and closed higher.

–Speaking of oil, you might have missed the story earlier this week that Saudi Arabia—the world’s biggest oil producer with the world’s largest proven oil reserves—actually cut production of oil in March…by 800,000 barrels per day (bpd). Saudi Oil Minister Ali al-Naimi said the market was over-supplied at the time.

–The Saudis cut daily production from about 9 million bpd in January to 8.2 mbpd in March. For the market to be in oversupply, oil producers would have had to have misread the strength of oil demand. And of course by late March, after Japan’s 9.0 magnitude earthquake, tsunami, and nuclear crisis, you could easily make the “over supply” argument. Or at least, the “demand isn’t as large as we thought” argument.

–But there are two other possible explanations for the Saudi production cut that are not, shall we say, as direct. The first, suggested by DR reader Malcolm Martin, will be somewhat familiar to long-time DR readers. Malcolm writes:

The Saudis have repeatedly said that oil at over $85bbl acts as a brake on growth and is thus counter-productive. Well hello boys! Brent crude is at $121 and Nymex is at $107. Tapis crude (Singapore) which is where we Aussies get our black gooey stuff is at $129bbl as I write – and you wondered why you are paying $1.50+ per litre?

The Saudis say they’ve cut due to ‘a lack of demand’, despite the EIA and just about every other energy agency reporting ballooning demand from China and the rest of Asia!

There’s really only one explanation for this cut if my assessment is correct. Long time readers of my rants are aware that I firmly believe in Peak Oil – the theory that the world has reached its maximum level of production as is now starting to slide down the far side of the bell curve [Hubbert’s Peak]  that is the hallmark of all oil production whether it be from a single well, a country or the world as a whole.

This subject is far too complex to discuss here, so do your own research. But if I’m right, this Saudi cut is occurring because their reserves are dwindling and they simply can’t maintain production. And that, boys and girls, is truly, hugely, monumentally, significant, because it’s been widely believed that Saudi Arabia is the only producer that has the capacity to increase supply.

I’ll get out your way now, having vented my spleen with sufficient gusto. But I’ll leave you with a quote from those very same Saudis which originated many years ago when oil was first discovered in the kingdom:

“My father rode a camel, I drive a car, my son rides in a jet plane, his son will ride a camel.”

–Is Malcolm right? It’s possible. At the very least, he highlights a point we brought up in the last issue of the Australian Wealth Gameplan: the security of oil and energy supplies from the Middle East and North Africa is now…not so secure. It could be good old-fashioned depletion and the inability to replace reserves. Or it could be one final possibility.

–The final possibility is that the Saudis are using oil as a weapon. They’ve done this before. One of the more interesting theories about the cold war is that it wasn’t Ronald Regan, Margaret Thatcher, or John Paul II that defeated the Soviet Empire. It was Saudi Arabia! Check out the chart below and you’ll see what we mean.


–There are three periods on the chart to illustrate what could be examples of “the oil weapon” being used. At the very least, they’re examples  of the unique geopolitical sensitivity of the oil price. Let’s unpack them.

— The first period, in the blue circle, saw oil rise 183% from $3.56 to $10.11. U.S. President Richard Nixon had “closed the gold window” in America in 1971. You couldn’t redeem U.S. dollars for Fort Knox gold anymore. That’s the year the world went on a de-facto dollar standard with the dollar as the world’s reserve currency.

–Part of oil’s move, then, could simply be the inflation that ensued as the dollar was uncoupled from gold and real things began going up in price (or the dollar began going down in value). It’s also possible OPEC managed the oil price to punish the United States for trying to buy oil with cheaper dollars. If someone were paying you with inflated currency, you’d raise prices too (even if they were selling you weapons as well).

–And speaking of weapons, there was also the Yom Kippur War in 1973. Syria attacked Israel in the East in the Golan Heights and Egypt attacked in the West in the Suez. The war ended in a stalemate, but showed what a tinder box the world’s biggest oil-producing region was, and would be for years to come. It’s also possible that the higher oil price could have been the Arab world’s way of punishing the U.S. for its regular support of Israel.

–The red circle on the chart shows oil’s rise during the Iranian Revolution. Oil went up 183% in the 18 months between January 1979 and July of 1980, from $14.05 to $39.55. This price rise coincided with high inflation all over the Western world. At least part of oil’s gain, then, is attributable to inflation.

–The doubt about the security of Iranian supplies was clearly a big factor. Iran is a founding member of OPEC. It has the world’s third-largest proven reserves of oil (137 millionbarrels) and second-largest reserves of natural gas. And for you history buffs out there, we learned in our investigations for the next issue of AWG that the West’s first oil ventures in the Middle East were conducted through the Anglo-Persian Oil Company in 1908.

–The Anglo-Persian Oil Company represented the interests of the British government in Iran (Persia). The company had been granted a 60-year lease to look for oil in 1901. It pumped its first oil in 1908. And it represented Britain’s focus on the Eastern part of the Gulf of Arabia, including Iraq and Kuwait. That left the Western part of the Gulf, and Saudi Arabia, to American interests. But that is a story for AWG subscribers for next week!

–Our point is the Iranian Revolution ended the West’s energy dominance in the Gulf. In some ways, all the wars since have been fighting over how much influence European and American powers will continue to exert over the region. Oil is either used as an economic weapon by producers, or effectively weaponised by outside interests who are willing to take it by force. But we digress.

–The last circle on the chart is the strangest of all. It shows oil rising by 105.7% between March of 1986 and July of 1987. It went from $10.40 to $22.40—during a time in which there was no major armed conflict in the Middle East. Granted, this did come after the 1985 Plaza Accord between the G-5 nations in New York. Central banks in America, Japan, the UK, France, and West Germany agreed to intervene in the currency markets to strengthen the Yen and weaken the greenback. Why?

–The U.S. trade deficit with Japan was a political hot potato at the time. The U.S. pressured its trading partners to allow a decline in the dollar to boost U.S. export competitiveness and close the deficit with Japan. It didn’t really work. But it did, coincidentally (oh those unintended consequences) lead to a huge bubble in Japanese property and stocks as foreign capital flooded into Japan and drove assets up unsustainably high.

–But does the 1985 Plaza Accord account for all of oil’s gain? There is an argument—which we won’t explore in detail here—that the Saudi’s flooded the oil markets with surplus crude in the mid 1980s at the request of the U.S. Their aim was to use their surplus production capacity to push oil prices down below the cost of production of Soviet crude oil.

–Crude oil was one of the only exports the Soviets could sell to raise foreign currency reserves. Without it, the Soviets would run out of money. This school of thought says that Reagan bankrupted the Soviets not by outspending them but by crashing the price of their main cash export. Whether it’s entirely true or not, the Soviet Empire did collapse, surprisingly quickly, just a few years later.

–As a side note, Reagan may have helped win the battle against the Soviets by losing the war against deficits. He cut taxes, but never seriously tackled U.S. spending, which led to large, structural, and permanent U.S .Federal deficits. They’ll be permanent until the U.S .defaults and can’t spend at all.

–You can see that there’s an intriguing argument that the Arab world has always used oil as a weapon, just as America has always used the dollar as a weapon. When you look at the chart of West Texas Intermediate Crude below, you can see that oil has again risen on Mid East tension (mostly Libya). But the Saudi oil production cuts came before Japan’s earthquake and before Libyan oil production fell dramatically. So if the Saudis are using oil as a weapon, who are they using it against?

–Tomorrow, we’ll take up the issue of who the Saudi’s might be targeting this time. And we’ll do what we said we’d do yesterday, which is to talk about how inflation is already out of the bag here in this part of the world and how you might hedge against it.

–For today, it’s clear that oil is rising for a series of geopolitical AND monetary reasons. And we haven’t even added warfare to the mix…yet. AWG readers stay tuned for the full story next week.

–Finally, thanks for dobbing in the stock brokers who have been distributing our newsletters to their clients for free. We got plenty of feedback on who’s doing it. We have the names of brokers in Melbourne, Perth, and Sydney who have either been passing the work off as their own or just distributing en masse. Apparently our work is not big in Adelaide, Hobart, or  Brisbane!

–We’re following up with our lawyers on the best way to pursue these miscreants. We’ll keep you posted. And thanks again.

Dan Denning
For Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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4 Comments on "The Oil Weapon is Wielded"

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5 years 6 months ago

On Iran I recommend William Morgan Shuster’s “The Strangling of Persia”

5 years 6 months ago

The article is titled “The Oil Weapon is Wielded” yet just when I thought you were going to explore this in detail you say

“There is an argument—which we won’t explore in detail here….”

Do you guys ever explore anything in detail?

No offence, but I really cannot imagine how bad a broker must be if they are distributing your rather light weight opinion as analysis.

Thanks for the little read…. it is obviously an issue with me that I keep expecting more depth from The Daily Reckoning.

5 years 6 months ago

No we read it in adelaide, we are just nice people :)

Ned S
Ned S
5 years 6 months ago

“No offence, but I really cannot imagine how bad a broker must be if they are distributing your rather light weight opinion as analysis”

It’s just a front to frighten everyone into paying money (which BB and DD will unquestionably convert to gold) for some more in-depth analysis/stock market tips maybe? :)

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