Monday, October 15, 2007

Thoughts on Oil

Oil hits $86.

I was discussing the reasoning behind invading Iraq with a friend. I suggested that there seems to have been a mix of reasons, but that preserving the petrodollar system and some naive notions that there actually was a terrorist threat from Iraq that we would somehow neutralize by removing the government of Iraq from power were probably two core reasons. He suggested that lots of the pressure came from the oil companies. This is really a no brainer, but I thought his rationale was interesting, and certainly not the standard oil-rothschild-skull and bones-conspiracy stuff. He pointed out that, for the second half of the 20th Century, the western oil majors had a simple business model: discover reserves and produce them. With the onset of the peak oil plateau, this model became invalid. The western oil majors were only discovering a fraction of their own production, and were increasingly forced into mythical write-ups of their reserves to maintain the validity of this business model. A new business model was possible, but it would require a geopolitical smokescreen to disguise the geological peaking of oil production. This new business model: increase the value of existing reserves faster than you produce those reserves, allowing the value of your company to continue to grow despite production out pacing discovery. Interesting thought--along the lines of intentional instability. I still think that oil companies are a terrible investment as it seems likely that their costs will continue to rise and that demand destruction will eventually invalidate this new model. But interesting, none the less...

Another thing driving up oil prices today: geopolitical tensions between the Kurds and Turkey. The bottom line is this: will the PKK attack the Baku-Tbilisi-Ceyhan pipeline? I've been arguing for some time now that targeting of energy infrastructure is the way of the future in asymmetrical conflicts. This seems to be playing out in Mexico, and the Kurds are certainly aware of its effectiveness as it is the attack of choice in Iraq. That said, the BTC pipeline doesn't pass through much ethnically Kurdish territory (it seems to clip the corner of Turkey's Kurdish region just southwest of Erzurum (Map 1 showing pipeline, Map 2 showing Kurdish region). Not that it would be that difficult for the PKK to attack this long and largely undefended pipeline outside of their home region, but it makes it arguably "less easy."

Also, take a look at this excellent article at The Oil Drum on the peaking of various minerals...


Ed said...

So is the new paradigm much like that of Goldfinger in the James Bond movie? Nuke Fort Knox so the value of your own reserves skyrockets within an economic lifetime.

Jeff Vail said...

I guess it is a bit reminiscent of Auric Enterprises. If you produce 5% of your reserves each year, but cause the value of those reserves to increase by 10% each year you end up with perpetually increasing sales and perpetually increasing book value despite zero new discoveries (you don't even need to resort to "reserve inflation"). Not a bad trick. Unlikely that the economy can absorb that kind of price increase for too long, but it certainly looks good within our quarterly/annual report time horizon.

nulinegvgv said...

of course facts like the lack of industry investment in new refinement capacity for 30+ years and the lack of support for high auto mileage standards don't seem so conspiratorial when examined with these thoughts in mind. but big oil still has to walk a fine line or as you mentioned, they'll sink the whole damn ship.

Salman said...

Jeff -

A finely crafted and peak-oil-icized representation of my comments. As for my own beliefs, my cynicism runs so deep I don't think I have any real views, just a set of plausible explanations I toy with, like a child, and put aside as fancy dictates.

Anonymous said...

This is really a no brainer

It sure is. *None* of the pressure to invade Iraq came from oil companies just as almost none of the oil interests involved in Iraq today are US-based.

Anonymous said...

preserving the petrodollar system

What on earth does the 'petrodollar system' have to do with Iraq? AFAIK there's been no change in the way US consumers pay for oil at the wholesale or retail level, since the US currency is still the dollar, the US is still the largest consumer of oil, and oil vendors by and large still choose to invest their proceeds in dollar-denominated (nb NOT US-domiciled) instruments like Eurodollars.

The idea that oil pricing is established by fiat is very silly. And it certainly doesnt impact policy.

Jeff Vail said...

Precisely--the oil companies operating in Iraq today aren't, largely, the western oil majors. That's the point--they weren't endangering their existing reserves by supporting such an operation, so they could increase the value of those reserves while not endangering them. Look up the largest source of funding for the AEI (ExxonMobile), then see what thinkers were produced and heavily influenced by the AEI. The connection is pretty clear.

I think you should look up "petrodollar recycling" before making too many comments on how world oil pricing works. The currency of retail purchases in the US is not the issue. Prior to the invasion Saddam switched to selling all Iraqi oil in Euros, from the previous requirement that all purchases be in US Dollars (and this WAS done by fiat). After the invasion the Coalition Provisional Authority switched back to ONLY US Dollar denominated oil sales (again, by fiat). And of arguably equal concern was the potential domino effect throughout OPEC, which is again at the forefront.

Anonymous said...

I think you should look up "petrodollar recycling" before making too many comments on how world oil pricing works.

I know very well how oil pricing works Jeff, I've traded it institutionally for over ten years. Oil 'prices' in every currency since as you probably know the currency market is vastly larger than the oil market, translating one to the other is effected by a trivial swap. Large as it is the oil market doesnt steer the currency market. Oil buyers need not pay in dollars and even if they chose to, the currency needn't be held with a US bank, so the US government isn't likely to derive any advantage from any "hoarding" of dollars for this comparatively narrow purpose.

P. Krugman has explained this well here:

The Iraq war didn't alter the price of oil -- overall exports from Iraq are roughly flat with what they were before the war. Oil prices are higher because of demand growth from Asia over which exxon is powerless.

AEI for its part is a huge think tank with hundreds of corporate donors, including some of the biggest oil consumers in the world, many of whom have been hurt badly by the rising price of oil -- car companies, food companies, other huge industrial end users whose combined market cap is many times larger than Exxon's. Were they absent from the secret meetings to hike the price of oil?

Jeff Vail said...

You seriously think that the Iraq war hasn't impacted the price of oil? OK.

I realize that currency markets are larger than oil markets, but that doesn't change the fact the impact of several hundred billion dollars a year being changed to dollars to buy oil, and then those oil exporters keeping their revenues in dollars. This process finances our budget deficit, permits our balance of trade deficit on an ongoing basis, etc. While there are certainly some exporters who don't require payment in dollars (increasingly a result of a conscious effort to move away from the petrodollar system FOLLOWING the invasion of Iraq by the likes of Iran, Venezuela, Kuwait etc.), many still require dollar payments, and the US would like to see a total return to dollar denominated oil on the international market...

Anonymous said...

You seriously think that the Iraq war hasn't impacted the price of oil? OK.

To me it obviously hasn't but I'd be interested in any reasons why it might have. As I mentioned the overall production statistics are in line with oil-for-food levels and have been for some time. Iraq headlines simply don't move the oil market up or down.

that doesn't change the fact the impact of several hundred billion dollars a year being changed to dollars to buy oil

They aren't being 'changed to buy oil'. Most petrodollars are held electronically in foreign banks (only fractionally backed by any kind of cash in vaults) which does nothing to subsidise US debt or balance of trade. Krugman's piece above explains this very well: "the U.S. does in effect get a zero-interest loan out of the dollar's international role--but it probably amounts to only a few billion dollars, small change for an $8 trillion economy"

The decision to retain oil proceeds in USD denominated assets is largely due to higher USD rates set on the open market. BTW OPEC countries lend not only to the US government, but anyone else issuing bonds in dollars - including all kinds of foreign banks, corporations and governments. China itself issues billions in Yankee bonds.

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