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     May 29, 2008
US-made oil disaster has mileage
By Hossein Askari and Noureddine Krichene

There is no end in sight to the recent strong gains in oil prices, endangering world economic growth and food equilibrium. This prediction is supported by our own modeling, which indicates that prices are more likely to go up than down in the near future. Could this mess have been avoided, why did it come about and what can be done?

The short answer is that the US Federal Reserve was in large part responsible for the oil price explosion and its volatility, while two successive US administrations have created the oil supply


shortfall, again adversely affecting oil prices.

First, let's step back. Analysts are of course correct when they point out the obvious, that the oil and natural gas demand-supply balance is very tight and that this is the fundamental reason behind rising oil prices and its volatility.

For a number of years, energy demand has been growing rapidly, especially because of faster world economic growth, notably in China and India. The growing demand for oil and natural gas has been further reinforced because of environmental and safety concerns, in turn adversely affecting the demand for coal and nuclear energy. At the same time, supply and excess capacity of oil (the ability to produce more oil if needed) have not kept up. We will have more to say on the supply shortfall below.

But some analysts miss the wider picture on both the demand and supply side. The demand for oil and gas has been driven by a number of other factors. The Fed has injected an unprecedented level of liquidity into the market. Since 2001, by adopting an interest rate rule, the Fed has followed the most expansionary monetary policy in its history, setting interest rates at low levels and real interest rates at negative levels.

In response to the collapse of the credit and speculation boom, the Fed has set a deliberate re-inflationary objective in order to reverse falling asset prices. It has aggressively resumed its expansionary monetary policy since August 2007, cutting the federal funds rate from 5.25% to 2% with a consequent faster expansion of money supply, resulting in a rapidly depreciating dollar and disrupting stability in commodity markets, propelling oil prices from US$65 to $135 per barrel.

A depreciating dollar and rising oil prices have gone hand-in-hand. Oil prices are quoted in dollars; a falling dollar results in an increasing dollar price for oil. Given a falling dollar, oil producers and others with surplus dollars are reluctant to store their wealth in dollars but instead are diversifying into other currencies, largely the euro and the yen, again putting further pressure on the dollar and again driving up oil prices; or in some cases producers cut back output as they are reluctant to hold more dollars.

The reluctance of oil producers to expand oil output is best illustrated by Saudi Arabia's recent lukewarm response to US pressure for increased oil production. As inflationary expectations have become firmly rooted, oil and food producers know they can generate more revenues by restraining supply. This vicious circle is all but obvious to anyone whose head is above water. Yet, it has somehow seems to have escaped the Fed's radar in Washington.

In large part because of the Fed's actions above and more specifically because of low or negative real interest rates, a falling dollar, economic uncertainty and volatility, investors and speculators have exacerbated market conditions. With low or negative real interest rates and a depreciating dollar, investors have been reluctant to accumulate dollar-denominated assets.

Commodities, especially oil, have afforded them a good hedge. Speculators, understanding fully the weaknesses of the Fed's current policy and its imminent consequences on oil and natural gas markets, have seen an opportunity to profit from the prevailing policy stance. This added demand of investors and speculators has also fueled the oil market, but to what extent nobody can tell for sure.

Mystery of missing output
In most markets, rising prices can be expected to encourage more output or supplies, albeit sometimes with a lag. Why has this not happened in the oil and natural gas markets? First and foremost, oil is not a commodity such as shoes. It takes anywhere from about three to 10 years to develop an oil field and bring the oil to market, depending on the location and other characteristics of the field.

Second, given low oil prices from the mid-1980s until the late 1990s, there was little incentive to develop new fields. As a result the level of excess capacity to produce oil has been low. So when markets are tight, as they are today, there is little additional production that can come on line quickly. Making matters worse, the small excess capacity that exists today, on the order of 500,000-1,000,000 barrels per day (mbd) and in the range of 1% of daily global consumption of about 87 mbd, is all in members of the Organization of Petroleum Exporting Countries (largely in Saudi Arabia).

But the real issue that seems to have escaped all these oil analysts is the overriding reason why additions to oil supplies (and the capacity to produce more oil) have been so small in recent years? This can be laid at the door of the White House; the George W Bush administration and its predecessors have caused the current supply shortage through their policy stance towards the Persian Gulf region and especially towards Iran and Iraq.

Let us explain. The most promising region in the world for further large additions to oil (and gas) reserves and to future output has been, and still is, the Middle East, or more specifically the Persian Gulf region. Specifically, additional oil and gas output is most likely to come first and foremost from Iraq, followed by Iran, Saudi Arabia and the Caspian region. Let's examine Iran, the Caspian and then Iraq.

Why has Iran's oil output declined and the country, which has the world's second-largest natural gas reserves, not made a bigger contribution to the global gas market? Some of the reasons are of Iran's own making, many are due to US sanctions on the country and US political pressures on other countries to isolate Iran.

Iran lacks the funds to rapidly develop its oil and gas sectors, and it has had reduced ability to attract foreign investors. US firms and financial institutions, some of the prime developers and financiers of oil and gas fields in the world, have been sanctioned from participation in Iran; and most prime European firms have been unwilling to ignite US retaliation by participating in Iran. The factors have reduced competition for Iranian energy assets and have limited the appetite for investment in its oil and gas sector.

While Iran's oil output was hovering around 6 million barrels per day at the time of the Iranian Revolution in 1979, today it stands at about 4.3 million barrels per day. Still the effect on Iran's energy sector may be most apparent in the absence of pipelines to carry Iranian gas to European markets.

Hostage to Russia
Europe, at present held hostage to the availability of gas from Russia, will eventually have no choice but to develop and pipe Iranian gas. One indication that this is being recognized came in March, when Switzerland signed a $42 billion, 25-year gas deal for Iran to deliver, from 2010, 5.5 billion cubic meters (bmc) of gas per year to Europe via a pipeline under construction. (See Energized Iran builds more bridges, Asia Times Online, May 6, 2008.)

India's need for Iranian gas is another urgent supply need, yet the US pressures against pipeline development and fuel delivery. These projects, and more, if developed, would have increased energy supplies (as oil and natural gas are substitutes in a number of uses) and have added to global capacity, calming markets.

The situation is similar for development of Caspian gas and oil. The land underneath the inland sea may contain the largest potential additions to global reserves outside the Persian Gulf, yet development has been slow as the five littoral countries have failed to resolve differences on how to define the Caspian (a sea or a lake), the legal force of historical agreements, and thus how to divide the minerals under the seabed. (The five countries are Azerbaijan, Iran, Kazakhstan, Turkmenistan and Russia.)

The US has pressured the former Soviet republics not to cooperate with Iran. At the same time, while the most cost-effective route for bringing Caspian oil to market would be through Iran, this has been blocked - again by the US. Washington has also vetoed swaps of Iranian oil in the south of the country, where it can be exported, for Caspian oil deliverable to Iran's northern refineries.

Iraq is widely predicted as having one of the world's two largest oil deposits. Yet the country, having produced only about 2.6 mbd in 1999 under the United Nations sanctions regime, is today producing even less, at about 1.9 mbd.

The broader state of varied political tensions throughout the Persian Gulf region reduces the attraction long-term investment in oil and gas infrastructure. (The extent that this is due to US policies toward the region will be discussed in a future article.)

Even so, global oil output could be expanded by up to 10 mbd and natural gas supplies by the equivalent of another 5 mbd within five to seven years if sanctions on Iran were lifted, the Iraqi conflict was brought to a halt, and Saudi Arabia's expansion programs came on stream. That would be enough to transform the global energy market.

The world community must face up to a number of stark facts. The global energy squeeze is not going to go away any time soon. It has been years in the making. Fed policy has had adverse effects on the demand side, resulting in escalating prices and volatility. US policy towards the Persian Gulf region has exacerbated current and long-term supply conditions.

Fed policies may be difficult to turn around; a drastic change in US political policies towards the region may be even more problematic but even more necessary. But such a change could calm global energy markets and go far towards restoring economic prosperity and social order to the world.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist at the International Monetary Fund and a former advisor, Islamic Development Bank, Jeddah.

(Copyright 2008 Asia Times Online Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

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