The Double-Edged Sword of Financialised ‘War’
Conflicts Forum’s Weekly Comment, 12-19 December 2014
The drop in the rouble has been truly dramatic. Overall, it has fallen more than 50% this year against the dollar. But it was Monday’s 10% fall against the dollar, followed by a subsequent 11% on Tuesday – despite a 6.5 per cent (or 650 basis points) rise in interest rates by the Russian Central Bank – that hinted of a possible collapse. The interest hike however did little to buttress the rouble in the short term and (a gleeful) mainstream western media speculated whether President Putin’s hold on power was slipping away – along with the tumbling rouble. Now, however, the rouble appears to have stabilised. It seems (there is no hard proof), that China may have been stabilising the currency on Wednesday and Thursday (see here) — a move which, if true, would mark a significant politicisation of China’s foreign policy (and a reflection of China’s strengthening strategic alliance with Russia).
Whilst Western mainstream focus has been on Russian discomfort – triggered by the plunging price of crude – there has been a notable lacunae in the attention paid to the other side of the equation: Any major crashing (or raising) of the oil price is a notoriously blunt instrument. While there can be no doubting its raw power, it is a double-edged sword. In an global era of zero (and now negative) interest rates (ZIRP) and of the flood tide Central Bank liquidity (QE), it is certainly no ‘precision weapon’, but rather a scattergun of potential contagion. It is as likely to bring down friends, as much as enemies. And its ultimate consequences almost certainly will be both unforeseen, and may well end being as damaging to the West as to either Iran or Russia. In short, it may affect the Middle East in ways that are far from those intended (that is to say by coercing Iran in to making further concessions over its nuclear programme & over President Assad).
Wielding the blunt instrument – and its ‘unknown unknowns’
Saudi Arabia has a history of using oil as a political tool. In 1976, the Saudis flooded the oil market (concerned by the Shah’s nuclear programme, and growing Iranian influence). Oil production was upped from 8 million to 11.8 million barrels per day, slashing crude prices. Iranian industry was severely affected, and a few weeks later the Shah had to admit: “We are broke”. Saudi Arabia had helped collapse the Shah (rather than weaken him), and within two years, the Shah was truly eclipsed. He was eclipsed though, not by pro-western politicians, but by revolution, and the advent of Imam Khomeini.
Ronald Reagan’s son recently related how his father in the early 1980s “got the Saudis to flood the market with cheap oil: Lower oil prices [down to $12] devalued the rouble, causing the USSR to go bankrupt, which led to perestroika, Mikhail Gorbachev – and the collapse of the Soviet Empire”. But this ‘coup’ (acknowledged by many Russians) ultimately has led to the US facing a Russian leader who is yet more determined to establish the right of the non-West to be non-western.
In November 2006, an op-ed in the Washington Post written by an aide to Prince Turki noted that “[i]f Saudi Arabia boosted production and cut the price of oil in half … it would be devastating to Iran … [and would] limit Tehran’s ability to [support] Shiite militias in Iraq and elsewhere”. Two years later, at the height of the 2008 financial crisis, the Saudis again flooded the market, and within six months, oil prices had fallen from their record high of $147 per barrel to just $33. The economic impact of this initiative almost succeeded in cleaving Iran apart – arriving, as it did, in tandem with the 2009 Green dissidence movement. The then-president, Ahmadinejad, however was not toppled, and today’s Iranian President is highly lauded everywhere, with the Americans anxious to seal a deal with him.
In 2011, Prince Turki bluntly warned that Iran should not try to take advantage of the regional unrest known as the Arab ‘Spring’. The former Ambassador and Saudi intelligence chief cautioned that Iran’s economy could be squeezed hard by “undermining its profits from oil, something the Saudis … were ideally positioned to do”, he underlined.
Then earlier this year, Prince Saud al-Faisal, frustrated by the coalition’s failure to oust President Assad, called on allied western Foreign Ministers to put more pressure on President Putin to halt his support for President Assad. The best way to force a change in Russian policy, the Prince said, was to crash the price of oil. In practice, Saud al-Faisal’s initiative was to kill two birds with one stone (to curb Iranian support for Assad, and to force a change in Russian policy with respect to Syria too).
The same aide who had written the 2006 Washington Post op-ed, has written with respect to today’s oil price crash that his government’s decision to depress prices is “going to have a huge effect on the political situation in the Middle East. Iran will come under unprecedented economic and financial pressure as it tries to sustain an economy already battered by international sanctions.” This too, seems to be Washington’s calculus (see below). But even now, with the oil price halved, President Assad remains secure in his position. And Iranian and Russian policies, at least for now, stand unchanged. With respect to America’s shale oil revolution, however, it may appear that Saudi Arabia has achieved one of its targets; but even here, the old adage ‘be wary for that for which you wish’ may be appropriate. And if reports are correct that Secretary Kerry sanctioned the ‘Oil War’ at his meeting with Saud al-Faisal in September (hoping to land a devastating blow on Putin) are correct (and recall that Brenner was a long serving CIA Head of Station in Riyadh with a particular interest in oil politics), Kerry too, may yet rue the possible blowback.
Blowback – dollar strength is making the flood of near zero cost, electronically created dollars, thrown at markets around the world in recent years, suddenly ‘suspect’
This time, however, the price crash is essentially different. Saudi Arabia has chosen it’s timing well: it has crashed the market at a moment of collapsing demand (with a global weakening of economic activity) and of new supply (America’s shale) contributing to output. These have magnified many times over the relatively light ‘trigger pull’ initiated by the Kingdom. But what makes this price crash different from those in the past is something barely appreciated: Namely, the change in western monetary policy that occasioned the dollar’s de-coupling from the petrodollar system. It may seem arcane, but that does not mean that it lacks significance.
Until the ‘Dot-Com’ bust in 2001, the US Federal Reserve had managed domestic American interest rates to keep the US dollar roughly in parity with a given quantity of crude (a $1000 face value Treasury equated more or less to 55-60 barrels of oil over three decades). But then a new monetary orthodoxy arrived at the Fed: massive money creation and zero interest rates. Since that time, the dollar has become a pure fiat currency (linked to nothing in particular and whose ‘strength’ was more a matter of perception, than substance). The financial ‘system’ has been for the last eight years on ZIPR and QE life-support. It cannot be ‘touched’ without risking systemic collapse. So what do we have? Basically energy producers’ currencies go down as crude falls – and the dollar – cut from its oil anchor – inversely goes up. On the back of crude’s fall, energy producers’ currencies have been slammed lower (the rouble being the most prominent). Crude has fallen by half, and the rouble quite logically has been allowed to fall by half.
Normally, as a former Assistant Secretary to the US Treasury writes, “when massive amounts of debt and money are created [QE], the currency collapses; but the dollar has been strengthening. The dollar gains strength from the rigging of the gold price in the futures market. The Federal Reserve’s agents, the bullion banks, print paper futures contracts representing many tonnes of gold and dump them into the market during periods of light or non-existent trading. This drives down the gold price (despite rising demand for physical metal). This manipulation is done in order to counteract the effect of the expansion of money and debt on the dollar’s exchange value. A declining dollar price of gold makes the dollar look strong”.
When so many Central Banks are printing money madly, the ‘strength’ of any currency is purely relative (i.e. who ‘sinks’ the least), and is essentially a matter of perception – hence the Fed’s shenanigans in the gold market to create a dollar ‘perception’. The EU and Japanese managed currency devaluations (attempting to exit from recession) and their commitment to ‘printing money’ or QE, have further propelled ‘king dollar’ (in the sense that when all is around is volatile and crumbling, the dollar becomes ‘king’ – especially when American QE somewhat ‘tapers’, leaving it to Japan and the ECB to ‘goose’ asset values).
Doug Noland, the well-respected market analyst has noted, “‘King dollar’ [has] placed further downside pressure on crude and commodities markets. Collapsing oil and commodities has already impaired financial and economic stability for scores of countries and companies – too many with ballooned debt (much dollar-denominated), and [accumulated] throughout the previous boom. Huge amounts of global debt have rather suddenly turned suspect, inciting a self-reinforcing flight out of currencies, debt markets and commodities. And the more flows reverse out of the Periphery and head to the bubbling [but nonetheless perceived to be safer] Core, the more destabilizing the unfolding king dollar dynamic [will become] for the global financial ‘system’ and economy”.
So peripheral and Emerging Market (EM) economies are being severely squeezed, and the outward tide of cheap Fed- created, cheap liquidity is suddenly returning home, as the EM panoply of leveraged, dollar-denominated debt suddenly begins to look suspect.
‘Risk On’: Oil price fall becomes catalyst making whole categories of debt look suddenly unsustainable through the return, after a long hiatus, of the perception of risk
What does this mean? Shale Blowback: Firstly, the oil drop suggests that the ‘business model’ for US shale oil is so impaired as to be no longer viable for all, but a very few (who, in the short term, will try to expand production in the hope of putting higher cost competitors out of business). American Shale oil represented the conjuncture of two events: high oil prices and an incoming wall of near zero cost money coming from Wall Street (some $550 billion) with which to drill wells. The exuberance of the moment persuaded investors that their investment was virtually risk free (that crude prices would stay as they were – or would rise), and that shale companies would continue to pay interest on these debts (shades, again, of the sub-prime mortgage crisis). Suddenly, the perception of risk has dawned on investors. Some of this shale debt is sub-prime (in the housing sense that, were a mortgagee’s income to shrink at all, the loan becomes almost directly non-performing), and will lead to default.
Banks (and the hedge funds) hold this huge capital expenditure debt, plus the counterparty risk of having insured companies for future oil price sales that are nearly halved. In the coming months, this will weigh on bank balance sheets and sour credit markets – especially as shale – unlike conventional oil – requires a continuing and escalating investment to drill ever new wells as the old deplete far faster than conventional ones, where too, typically, capital expenditure is more front-ended and ‘historic’, for conventional wells, rather than ongoing, as with shale. The few stronger shale companies may continue to produce oil – even if this means negative cash flow – but investors are unlikely ever again to look at shale as a ‘miracle’ money-maker. As Bloomberg notes:
Fed Bubble Bursts in $550 Billion of Energy Debt: The danger of stimulus-induced bubbles is starting to play out in the market for energy-company debt … With oil prices plunging, investors are questioning the ability of some issuers to meet their debt obligations. Research firm CreditSights predicts the default rate for energy junk bonds will double to 8% next year. “Anything that becomes a mania – it ends badly,” said Tim Gramatovich, chief investment officer of Peritus Asset Management. “And this is a mania.”
And it is not just shale that is trouble — Internatioinal Oil Majors are also feeling the squeeze. An analysis by Goldman Sachs this week looked at 400 of the world’s largest new oil and gas fields — excluding U.S. shale – and found that almost $1 trillion in investments in future oil projects are at risk. These ‘zombie projects’ (Bloomberg’s language) proliferate in expensive Arctic oil, deepwater-drilling regions and tar sands from Canada to Venezuela.
“It’s almost impossible to make money at these oil prices”, Mr Allan, a director of Premier Oil in addition to chairing Brindex, told the BBC in respect to North Sea prospects. “It’s a huge crisis … It’s close to collapse. In terms of new investments – there will be none, everyone is retreating; people are being laid off at most companies this week and in the coming weeks. Budgets for 2015 are being cut by everyone.”
And this is the point: the crashing of crude – in this new monetary world of inverted relationship between the dollar and oil – plainly is impairing prospects for US shale companies and International Oil Companies. But it is also true that in this new ‘monetary policy world’, the fall in crude, commodities and EM currencies, make it much less likely that periphery and EM countries will be able to service huge amounts of dollar-denominated debt.
The big threat: All the leveraged, dollar-denominated, near zero cost, hot money pumped by the trillion into emerging markets in search of yield now looks impaired.
Just as unlimited dollar liquidity at near zero ‘cost’ ‘created’ the supply of shale oil, so the $5.7 trillion ‘thrown’ by Wall Street at EMs in terms of near zero give-away Fed liquidity – denominated in US dollars – has not just kept emerging economies alive since 2008, it has given them the aura of growth (via asset inflation), but it was a growth that was temporary (and somewhat chimeric) all along — as illusionary as Europe’s ‘recovery’. There is now the risk of a rush for the rapidly closing market ‘exits’ as the contraction takes hold. And if emerging economies falter (as they presently are), will European and American financial institutions, which hold large amounts of EM debt, survive a new crisis? Shale oil has provided much of America’s new jobs and GDP growth. From whence will now come the economic growth that will melt away the overhang of national debts? Those who have been smirking at Russia’s distress could well find themselves subsequently distressed too.
Will the Oil War’s original targets – Russia and Iran – go down too?
So much for the ‘unknown unknowns’ of the Oil War, but what of its target: President Putin? The latter has said plainly that Russia faces a difficult time, and ordinary Russians have been racing to buy imported consumer durables before prices double. But in one respect, Russian energy companies are better placed than is widely appreciated (and are in a very different position for example from those of American shale companies). Russian energy companies’ revenues are still linked to dollar prices – yes, but all their expenses are in roubles (whereas shale companies’ expenses are in dollars – albeit for some shale companies perhaps moderated by new cost–cutting technology).
However, because of the rouble devaluation, the rouble revenue of Russian companies – and therefore their margins – have been unaffected, and for some, rouble revenues have actually increased. Indeed since gas prices have fallen much less than crude (some 20% versus 50% for crude), rouble devaluation will give a definite lift to revenues. A recent study has shown that the energy industry as a whole actually contributes only 16% to total economic output in Russia.
Overall, Russia, has a small government debt and a maturing dollar-denominated debt roll-over for 2015 that is manageable within the total of its FX reserves. But more than these cold statistics, Russia is in possession, above all, of the huge advantage of having a population that has a well-proven ‘pain threshold’ in the face of adversities that is much higher than, say, that of contemporary Europeans.
Nevertheless, pressure on Russia continues apace. As a very well-connected Washington commentator notes that whereas President Obama has signed into law a bill allowing for more far-reaching sanctions against Russia and the supply of military equipment to Ukraine, “Obama does not intend to enforce these powers for the time being – partly out of concern about opening a gap with the EU – but the move has added to his leverage against Russia. Administration officials tell us that they are hopeful that the collapse in the oil price will make Russia amenable to a settlement … Here too [in the P5+1 negotiations with Iran] the falling oil price is thought by US officials as increasing Iran’s incentives – even among the hardliners – to reach an agreement”.
The Administration may have its assessment badly wrong. The ‘pain calculus’ is far from straight forward and may yet produce surprises.