The Seven Ages of Oil Part 2: Boom and Bust, War and Peace, Growth and Decline

The Seven Ages of Oil Part 2: Boom and Bust, War and Peace, Growth and Decline

By
March 4, 2015

Part Two of Two:

The Seven Ages Continued

In Part One of our feature story from last month, we covered the first four of the “seven ages of oil.”

  1. 1859-1870: Illumination Births an Industry
  2. 1870-1911: Rockefeller Creates the Multinational Oil Standard
  3. 1911-1921: A Pax on Arabia
  4. 1921-1973: Texas Oil Boom in the Gusher Age

You may recall that we definedthe seven ages of oil as those periods in time that saw oil price growth followed by periods of accumulated average price decline of greater than 30% (for clarity, all prices quoted are in real 2014 inflation-adjusted dollars). Oil has taken a deep dive since its high of nearly $150/barrel in June 2008, following the implosion of SemGroup, the oil and natural gas transportation company. In the last month, oil has been dancing a fickle strut between $48 and $54, in what some may call a dead cat’s bounce from the low of $45 that we talked about last month.

You may also recall that last month we quoted predictions from Goldman Sachs of a possible decline to $30 and from an Iranian Oil Minister a decline to $25. Had we waited another month, we would have quoted Citi stating that the current surge in oil prices is just a “head-fake.” And Citi would go even further by reducing their annual forecast for Brent crude and forecasting momentary drops to $20. We are in an oil glut not seen since the East Texas oil rush. Even with rig counts and drilling in decline, production in the United States remains at an all-time high. This is backed by EIA reports showing that the amount of oil stored by refiners, traders, and others are at the most extreme level in 80 years. And it is not only the United States in a position of flagrant over-production. The glut is so severe that the available storage may possibly become maxed out, which would obviously put incredible downward pressure on prices. US oil is on the brink of overflowing.

What is more, we are back to the heyday of a global competition reminiscent of the Cold War, when Russia and the United States went head-to-head on all fronts. The cold, hot, cold war is heating up again with strife and global posturing over events in the Crimean Peninsula and the ensuing conflict in Ukraine. Just like the United States, Russia is also pumping oil at record levels. Not to be left out, Brazil is pumping out oil feverously, and the pivotal OPEC nations are strong on production and cutting prices. Saudi Arabia, Iraq, Iran, and Kuwait are offering prices to Asia that have not been seen for fourteen years. The times are reminiscent of Rockefeller’s classic monopolistic market saturation and the price discounting ploys of Standard Oil and similar stratagems deployed during the US oil oligarchies of the Texas Oil Boom. But back then, as now, not everyone could chase the European or Asian markets, and the current prices are absolutely not sustainable. There has to be fallout. The question is: who is going to bail, or be excised, from the market?

The transformation of the United States, enabled via the innovations in fracking technology introduced by George P. Mitchell, from a net importer fighting a global war for energy security to total energy liberation by the shale boom has wholly changed international political and economic relations. The Obama Administration is actively opening up a new front on the war on oil by clearing the way for the shipment of as many as a million barrels per day of ultra-light US crude to the rest of the world. A four-decade ban on oil exports could be lifted, thus plunging the United States headlong into the battle for Asian and European markets.

With energy independence achieved in the United States, and the world’s largest oil market effectively closed to any significant imports, everyone must be asking the question of relevance – who will be the relevant oil nations of the future? Or more specifically, can the OPEC nations have relevance in the future when they no longer form an integral part of the Pax of Western nations?

It is hard to imagine a time when the Middle East was in more disarray than it is now. The crisis that exists following the Iraq War, Arab Spring, and the current rise of ISIS dwarfs the events of the Yom Kippur War and conflict with Israel. And now, with the change in the global energy play, the last ace in the Middle East may have fallen. But let us not get ahead of ourselves. How did we actually come to a point where we are asking if there is a future for OPEC? We will answer that question and others as we cover the final three of the seven ages of oil:

  1. 1973-1994: The Middle East Shrugs its Shackles
  2. 1994 -2008: Deregulation, Speculation, Manipulation, and Detonation
  3. 2008-2015: All Fracked Up

Slide1

1973-1994: The Middle East Shrugs its Shackles

It is important to understand that the oil industry is largely a Western invention and is very much American led. When America began making overtures to King Ibn Saud of Saudi Arabia in the post-depression years, the British balked. At this time, Ibn Saud’s kingdom was a fractious collection of warring nomadic bands spread out across a desert wasteland. They were only brought together with a heavy hand. The worldwide depression reached its long fingers into the desert as well. The King was desperate for money. The American gamble won out. Quickly thereafter, with the discovery of oil, the American oil companies began transforming the Middle East into an oil economy. America had established itself firmly in the Middle East, much to the chagrin of the British.

Ironically, as the US was making headway in Arabia, establishing a firm foothold in foreign oil reserves, the rest of the world was pushing back against its former colonial masters. Nationalism was the word of the day and would be a contributing factor to the Second World War. Indeed, WWII fueled nationalistic fervor across the entire oil-producing world, most notably in Iran and Venezuela. These two countries would be critical in bringing about OPEC. While the idea initiated in Venezuela, it would be ratified in Baghdad. Ostensibly, it was the intention of the five founding members – the Islamic nations of Iran, Iraq, Kuwait, and Saudi Arabia along with Venezuela – to mitigate the price control ability of the Seven Sisters. The Seven Sisters were the global oil majors of ESSO, Shell, BP, Mobil, Chevron, Gulf, and Texaco. It was perceived, justifiably, that the Sisters were able to keep oil prices depressed to the benefit of Western growth, while exclusively benefiting from the balance of the integrated oil business. As nationalistic fervor and a reaction against what was seen as Western oppression (a greed for oil) intensified, OPEC would grow to include Qatar, Indonesia, Libya, The United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon, and Angola.

With the insertion of Israel into the Middle East, resulting in the Israeli-Palestinian conflict, tensions grew. But these tensions came to a head with the overt involvement of the United States in the Yom Kippur War. Iran had previously been stung by British and American involvement during the Iranian coup d’état in 1953. That operation was a blatant action to retain oil concession from the Anglo-Iranian Oil Company. Recall that Anglo-Iranian Oil was the biggest foreign asset of the United Kingdom at the time, which was remarkable, given the impressive colonial reach of the British Empire. This made the oil company a massive asset, one deemed critical to the security of the Empire.

The CIA staged the overthrow, hiring local thugs and importing others to overrun the streets. The payoff to the United States was a share of concessions that would last for 26 years and the control of Iran through a puppet shah. In the preceding years, every effort was made to smother Iranian nationalism, including crippling oil embargos and subversion; however, when clandestine operations and economic throttling fail, overt force has been the traditional means of securing Western interests.

Jumping ahead to 1973, in retribution for Egypt’s humiliation at the supposed hands of the Americans, OPEC sent a decisive message: self-determination for oil-producing nations – a permanent throwing off of the colonial yoke whether in the Middle East or South America. The resulting oil embargo and price setting ignited the Middle East tinderbox. The region has been burning fiercely for four decades. The flames, bombs, and gunfire have visited every Arab country and every Western nation in the form of terrorism. Terrorism, fanatic nationalism/Islamism, remains today the greatest threat facing the oil industry and global security.

The action by OPEC shook the very foundation of the Western Pax. The West, at least momentarily, was on its back heal. A negotiated transition to nationalism for oil producing nations was no longer a possibility. As the taps gradually closed, prices soared, resulting in 100-year highs. Rationing and long lines at the gas pump, fixtures of wartime, were revived. Energy security, and its direct association with national security and Western freedom, became the paramount issue of the 1970s. The oil crisis was upon the world. The exit from the Golden Age of prosperity for the West came at the stroke of a pen at the Kuwait meeting of OPEC on October 20, 1973. Over the next year, crude price would quadruple. World markets, already in turmoil after the untimely (short-sighted) unilateral cessation of the Bretton Woods Accord by President Nixon, were sent into further disarray. The hope to tie oil prices to the US dollar instead of gold may have been better served at a much later date.

Recession and inflation were to be banes of the financial world well into the 1980s. After 1980, hard economic times reduced demand for oil, and overproduction resulted in a glut on the world market. The result was a six-year slide in oil prices culminating with a 46% price drop in 1986. The 1986 oil price collapse may have benefited oil-consuming countries such as the United States, Japan, Europe, and many third-world nations, but it represented a serious loss in revenue for oil-producing countries in northern Europe, the Soviet Union, and OPEC.

The 1990 oil price spike occurred in response to the Iraqi invasion of Kuwait on August 2, 1990. Lasting only nine months, the price shock was less extreme and of shorter duration than the previous oil crises of 1973 and 1979-1980 when Russia invaded Afghanistan. Still, the spike and global fears may have been enough to trigger the recession of the early 1990s. Oil prices more than doubled in October; however, as the American-led coalition experienced rapid military success in Iraq, concerns over oil supply alleviated and prices declined. Iraq would again surface as a paramount world concern 10 years later.

The recession would last until the latter half of the 1990s, when commoditization of everything was stimulated by the rise of the Internet and the introduction of electronic trading at home. But this too would results in a series of totally unexpected, unmitigated, and disastrous market crashes: the tech bubble (dot.bomb), the California energy crisis, and the mortgage and loan debacle. From 2000 onward, it seemed that every year brought a new financial crisis, and truly, a new threat to world peace. The SEC and Homeland Security have been beleaguered in their attempts to keep up with the myriad threats to US and global economics, energy, and peace.

 

1994 – 2008: Deregulation, Speculation, Manipulation, and Detonation

In the opinion of the author, our most recent energy woes really begin when regulators got it into their minds that they could be as instrumental in making markets as they were in regulating markets in the 1990s. The result was a recession almost as devastating as that of the 1930s. The national blight of the depression-era wheat boom and bust shares a lot in common with tech boom and bust as well as the rise and virtual collapse of electric deregulation. It seems that, in oil, we must be riding towards a total collapse – a bottoming out as dramatic as any that has come before. While there may be some winners (for example Warren Buffet and the Shareholders of Berkshire Hathaway who bought distressed technology assets in the 1990s and then energy assets in the 2000s at bargain basement prices), there will surely be many more losers.

Since 2001, the United States has seen the 10 largest US bankruptcies in history: Lehman Brothers, Washington Mutual, Worldcom, General Motors, CIT Group, Enron, Conseco, MF Global, Chrysler, Thornburg Mortgage, and Pacific Gas and Electric. The cost of these bankruptcies – $1.5 trillion. The amount of money the American people paid to bail out the big US auto makers and their brethren in the American Recovery and Stimulus Act – three-quarters of a trillion dollars.

This aforementioned bankruptcy list does not even include the seminal SemGroup implosion that many attribute as the pivotal event that triggered the current oil price slide. On July 11, 2008, as crude oil ascended to the lofty heights of $150/barrel, SemGroup of Tulsa, Oklahoma, was banking on a $5 billion payout. However, not all that glitters is gold, or black gold for that matter. SemGroup had made a financial play, a massive one; and as the market sentiment turned due to a variety of social, economic, political, and physical factors, so did the price of oil.

The New York Mercantile Exchange (NYMEX) made a call on SemGroup. Boom goes the dynamite, as they say. Short on oil, SemGroup was forced to put up immediate cash as collateral to cover its losing positions. Unable to raise the necessary capital, SemGroup gave over its entire crude-oil futures position to Barclays investment bank and posted $2.4 billion to the exchange. Go straight to bankruptcy court; do not pass go; do not collect on your position. Following the demise of SemGroup, the price of oil swiftly declined by 60% to fall below $60/barrel. SemGroup gambled all on a spotted pony.

The SemGroup story, save for the commodity, is similar to that of Enron, in that both organizations toppled due to an inability to meet a simple margin call. Management at both companies explicitly allowed traders to take positions that created massive exposure to unmitigated risk. In the case of Enron, market exposure was compounded by years of financial impropriety driven by a desire to increase stock price. Enron’s fall began with the sale of company stock in 2001 to meet margin calls. When it finally imploded, it was one of the 10 largest companies in the United States, and it became the singularly largest bankruptcy in history at the time. The dramatic death of Enron nearly took out electricity deregulation with it, along with a whole industry. The truth is, electric deregulation stalled in 2001 and never again recovered the momentum it once had. The fervent call of FERC to deregulate the nation ceased overnight. The state of California approached bankruptcy, whilst the California Power Exchange did go bankrupt as well as one of the state’s largest electric utilities, PG&E. The electricity crisis battered the nation, much like the tech bust before it and the subprime crisis and fiscal cliff that were to follow. In hindsight, it is surprising that the Enron model is still ingrained in much of the trading operations that exist today. Like Standard Oil, what was one large, uncontrollable entity has morphed into a plethora of speculative trade shops in financialized energy and commodity markets.

Following the oil crisis, the United States went into regulation overdrive in frenetic efforts to maintain energy independence, forestall a pending peak oil crisis, maintain competitive energy advantage, and build new energy markets. The resulting plethora of regulation has made and destroyed markets, made and destroyed corporations, and made and destroyed nations – largely in the quest for the energy independence and associated economic and corporate freedoms in a globalized commodity trading market. If we look just since the 1990s, we can get a sense of the back-and-forth nature of energy regulation and its associated costs and benefits:

  • 1992: Energy Policy Act (EPAct)
  • 1996: FERC Orders 888/889/890
  • 1996: NYMEX Electricity futures trading initiated
  • 1996: Alberta Power Pool, ERCOT, PJM introduced
  • 1998: Cal-PX Launched (Cal-PX bankrupt à Cal ISO)
  • 1999: FERC Order 2000
  • 1995: Energy Policy Act
  • 2001: FASB 133 Accounting: Derivative Instruments and Hedging Activities
  • 2002: Sarbanes Oxley
  • 2006: FERC Order 670
  • 2006: Global Solutions Warming Act of California Assembly Bill 32
  • 2007: Energy Independence and Security Act
  • 2007: Renewable Portfolio Standards
  • 2009: Regional Greenhouse Gas Initiative (RGGI): 32
  • 2009: American Recovery Act
  • 2010: Dodd-Frank Wall Street Reform and Consumer Protection Act
  • 2011: FERC Order 1000

 

2008-2015: All Fracked Up

The current oil price situation we find ourselves enmeshed in stems both from market speculation and the realities of a world awash in an oil glut, stemming from the fracking game changer. While it could have been predicted, it seems that few accurately imagined what the reversal of the United States from a net energy importer to a potential net exporter would have on world markets. On July 11, 2008, when the price of crude oil peaked at nearly $150/barrel, the short-lived oil distributor out of Oklahoma, SemGroup, imploded. On the wrong side of the forward price curve, a potential $5 billion market gain instead resulted in a discounted liquidation of positions and assets. With Semgroup in bankruptcy, the industry started its tailspin. Prices spiraled by 60% before the big bounce back to north of $100. In hindsight, the volatility and recovery did not have a true basis in fundamental analysis.

The price drop was not due to either reduced demand or new supply. Rather, speculation before and after July 11 drove the price both up and down. The war for superiority in the virtual trading space can be just as fierce as that fought on the far-flung battlefields. In one case, the soldiers, rebels, and civilian casualties lie dead in the streets; in the other case, traders, financial houses, and investors stare in dead remorse at the red line across their computer screens.

In truth, since 2010, and even today, the markets have been chasing the Asian dream – the possibly misguided belief that China would be a price taker as it sought out energy sources to fuel its economic boom. The reality was, and is, that China is actually the price setter as every nation discounts its price in a courtship dance with the East. This was abundantly clear last May when Putin undercut the world and signed a $400 billion multi-year gas deal with Xi Jinping of China. Overnight, the LNG terminal aspirations of the world were put at risk. The fact is that Putin may have been the first to realize that with the concept of peak oil firmly in the basement, a glut of every type of energy available, and the markets in recession, only the bold get the prize. Now, every nation is price discounting in a still errant chase of the white whale. Alarmingly, there are not enough white whales to go around. And should the need arise, China has its own abundant untapped shale reserves, as does its neighbor, Russia.

The conservation and energy policies that the 1970s brought about have been for naught, given the current glut and global energy market woes. Where is the green exchange, the RPS markets, the alternative energy rebates, the demonization of oil, and Middle East Peace? They are nowhere to be found in an energy world turned on its head.

These days, Obama prefers not to use the Nixonite term, War on Drugs, because drug abuse is a treatable disease. Obama also adopted the War on Terror that the junior Bush put in place post 9/11. The target was a Taliban almost as elusive as the purported weapons of mass destruction that falsely motivated the Iraq conflict 10 years after his father left the country with Kuwait oil fields blazing (but the Iraqi infrastructure intact).

Neither Bush was able to quell Iraq, even if the junior Bush hailed “mission accomplished” in a jumpsuit onboard a US aircraft carrier thousands of miles away from Iraq. Iraq is still a bloody mess. Saddam is dead. The Taliban nemesis has morphed into Al Qaeda, which has morphed into ISIS. And Obama is no closer to ending the illegal drug trade than he is at stopping terrorism. The Taliban is still strong and fighting in Afghanistan, and the country remains the world’s largest opium producer with record crops reported. Similarly, there is still rampant warfare in Iraq, and every week seems to bring a new ISIS beheading video. There is no exit from this, as there was no exit for Nixon from the energy crisis, no exit for Carter from the energy policy, no exit for Reagan for the Iran Contra affair, no exit for Clinton from strife in the Middle East (leaving Hilary to eventually deal with Hamas), no exit for either Bush from Iraq, and seemingly no exit for Obama from the Arab Spring and the revived War on Terror. And yes, all of this is about energy security and securing the price of a barrel of oil.

Today is a moment in time when every friction point of the past 125 years exits at once. There is monumental ideological conflict with Russia that has no end in sight. Almost every incumbent leader in the Middle East has been forcibly deposed (with US intervention) or died: Saddam Hussein (Iraq), Mohammed Zahir Shah (Afghanistan), Yasser Arafat (Palestine), Zine El Abidine Ben Ali (Tunisia), Hosni Mubarak (Egypt), Ali Abdullah Salah (Yemen), Moammar Gadhafi (Libya), and King Abdullah (Saudi Arabia). Any remaining autocrats beware.

Bashar Assad of Syria still stands, with the aid of Russia, but for how long? Sudan lies adrift in a murderous civil war that has raged too long and to which the world is largely blind. Almost every Arab nation is at war, preparing for war, or is in a war-like state. Should real conflict come to Iran, the outcome can only be disastrous, not just for the oil industry, but for the world. Surely, Russia will then come fully into the throw, to protect its own energy security and lay claim to its energy position in the East. With war at hand and markets in decline, every nation becomes desperate to retain market position – desperate to the point of irrationality or self-destruction. Who are the winners at $20/barrel oil? Possibly China and a few third-world consumers desperate to attain the Western standard of living could benefit. Certainly the current lower oil prices are a position much less tenable than that which existed prior to 1973.

 

An Implausible Future

Looking to the Middle East – what happens if you take a number of highly militarized individuals that are religiously inclined and factious, remove their leadership, fire their generals, disenfranchise their ruling elite, kill a number of their family members, impose sanctions, reduce their infrastructure to rubble, leave masses hungry, homeless, and angry? What is the only possible outcome? It is ISIS or something very similar to it. Remember that the Middle East is still seething over the arbitrary demarcation, segmentation, and division of the Ottoman Empire and Arabia, including the oil assets, in support of the Western Pax and the annexation of Palestine as war reparations.

With Afghanistan a feudal mess, Iraq a war zone, Libya in faction, Egypt in a tenuous balance, Syria in civil war, and Oman in peril, is it even remotely possible that any Arab nation feels secure?

The new Saudi King has a difficult challenge ahead of him: keep an oil-independent United States at bay; maintain a semblance of relevance in OPEC; concurrently stave off civil unrest, ISIS, and the brotherhood; and retain market share in Asia – all the while maintaining the economy in a market glutted with cheap oil when the nation’s primary industry is oil. He has to fail in at least one of these areas. So, hypothetically, if Saudi Arabia falls, and Iran becomes mired in a Western war, what happens to this house of cards? Will the essential Middle East peace sought during the Carter era devolve into chaos? And if Arabia falls and the United States becomes militarily involved in nuclear-enabled Iran (beyond mere economic sanctions), what will be the world reaction? Specifically, what will be Russia’s reaction?

The war on oil has heated up to its most dramatic point ever. On the surface, it may just look like another market bust, another technically based decline with some fundamental relevance. But in fact, it is s crumbling of the Pax in a new world order where every nation is trying to determine its relevance, and not just on the energy supply/demand relationship. What is more important – economic buying power and GDP growth in China or militarized might in the United States and Russia? And do the East-West conflagrations matter as tentative nuclear balance becomes unbalanced by new, less predictable entrants? With an economic blight on most of the world, including Europe and the United States, can we expect another fall of a Berlin Wall or collapse of a Moscow Kremlin? Will the Arab Spring run dry? Will political ideals and economic reality come to a head over low priced oil? Or will some new technical innovation, like the Internet or fracking, somehow create new wealth and stave off a global conflict? In the words of the immortal Yeats,

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

 

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