"The Real Problems With $50 Oil"

Henry C K Liu, Asian Times

After oil prices peaked above US$58 a barrel in early April, and stayed around
their current $50 range, the White House announced that it wanted oil to go
back down to $25 a barrel.

There is a common misconception in life that if
only things could go back to the ways they were in the good old days, life
would be good again like in the good old days. Unfortunately, good old days
never return as good old days because what makes the old days good is often
just bad memory.

The problem with market capitalism is that while markets can
go up and markets can go down, they never end up in the same spot. The term
"business cycle" is a misnomer because the end of the cycle is a very
different place from the beginning of a cycle. A more accurate term would be
"business spiral", either up or down or simply sideways.

Oil is a good example whereby this market truism can be observed. When oil
rises above $50 a barrel and stays there for an extended period, the resultant
changes in the economy become normalized facts. These changes go way beyond
fluctuations in the price of oil to produce a very different economy. Below
are 10 new economic facts created by $50 oil.Fact 1: Oil-related transactions involving the same material quantity involve
greater cash flow, with each barrel of oil generating $50 instead of $25. The
United States now consumes about 20 million barrels of oil each day, about 25%
of world consumption of 84 million barrels. At $50 a barrel, the aggregate oil
bill for the US comes to $1 billion a day, $365 billion a year, about 3% of
2004 US gross domestic product (GDP). About 60% of US consumption is imported
at a cost of $600 million a day, or $219 billion a year. Oil and gas import is
the single largest component in the US trade deficit, not imports from Japan
or China.

As oil prices rise, consumers pay more for heating oil and gasoline, airlines
pay more for jet fuel, utility companies pay more for oil, petrochemical
companies pay more for raw material, and the whole economy pays more for
electricity. Now those extra payments do not disappear into a black hole in
the universe. They go into someone's pocket as revenue and translate into
profits for some businesses and losses for others. In other words, higher
energy prices do not take money out of the economy, they merely shift profit
allocation from one business sector to another. More than $200 billion a year
goes to foreign oil producers who then must recycle their oil dollars back
into US Treasury bonds or other dollar assets, as part of the rules of the
game of dollar hegemony. The simple fact is that a rise in monetary value of
assets adds to the monetary wealth of the economy.

Fact 2: Since energy is a basic commodity and oil is the predominant energy
source, high energy cost translates into a high cost of living, which can also
result in a higher standard of living if income can keep up. High energy cost
translates into reduced consumption in other sectors unless higher income can
be generated from the increased cash flow. Unfortunately, in the modern market
economy, higher income for the general public often means working longer
hours, since pay raises typically have a long time lag behind price increases.
Working longer hours does not translate into productivity increases, but it
does increase income. Those who cannot find overtime work will look for a
second or third job, or put a hitherto non-working spouse back in the labor
market. This generally lowers the standard of living, with less time for rest
and leisure and for family and social life.

With higher prices, companies will hire more workers, since with wages
remaining stagnant and the cost of worker benefits declining while company
cash flow increases, adding employees will not hurt profitability and will
enhance prospects for growth. Those who get paid by fixed commission on
transaction volume are the winners. They see their income rise as the monetary
value of the transaction rises. This ranges from sales agents and gas-station
operators to real-estate brokers, investment bankers, mortgage brokers,
credit-card issuers, etc. This translates into higher aggregate revenue for
the economy and explains why corporate profit is up even when consumer
discretionary spending slows. It also explains why employment can be up while
the unemployment rate remains constant, because the new work goes mostly to
those already employed or those newly entering the job market, but not to the
chronically unemployed, who remain unemployed. A steady unemployment rate in
an expanding labor pool means that unemployment is growing at the same rate as
new employment. An unemployment rate of 5.2% — the US rate in April — is
within the structural range (4-6%) of what neo-classical economists call a
non-accelerating inflation rate of unemployment (NAIRU), thus presenting no
inflation threat.

Fact 3: As cash flow increases for the same amount of material activities, the
GDP rises while the economy stagnates. Companies are buying and selling the
same amount or maybe even less, but at a higher price and profit margin and
with slightly more employees at lower pay per unit of revenue. US prices for
existing homes have been rising more than 30% annually for almost a decade,
adding significantly to GDP growth. As the oil price rose within a decade from
about $10 a barrel to $50, a fivefold increase, those who owned oil reserves
saw their asset value increase also fivefold. Those who did not own oil
reserves protected themselves with hedges in the rapidly expanding structured
finance world. Since GDP is a generally accepted measure of economic health,
the US economy then is judged to be growing at a very acceptable rate while
running in place. People eat less beef and put the meat money into the gas
tanks of their cars to pollute the air, shifting cancer risks from their
colons to their lungs.

Fact 4: With asset value ballooning from the impact of a sharp rise in energy
prices, which in turn leads the entire commodity price chain in an upward
spiral, the economy can carry more debt without increasing its debt-to-equity
ratio, giving much-needed substance to the debt bubble that had been in danger
of bursting before oil prices began to rise. Since the monetary value of
assets tends to rise in tandem over time, the net effect is a de facto
depreciation of money, misidentified as growth.

Fact 5: High oil prices threaten the economic viability of some commercial
sectors, such as airlines and motor vehicles. US airlines United and Delta
recently won court approval to dump their pension obligations in a bankruptcy
proceeding. A need to bolster pension costs, underfunded by $5.3 billion, over
the next three years would worsen Delta's cash flow problems. Delta faces $3.1
billion in pension costs between 2006 and 2008. A bill under consideration by
the US Senate would stretch out employee pension payments over 25 years, and
could ease the airline's liabilities.

United Airlines sought and received approval of its plan to have the
government's pension insurer take over its defined-benefit plans, resulting in
the largest-ever US pension default. United workers will lose about a quarter
of their total pensions if their accounts are shifted to the government-run
Pension Benefit Guaranty Corp (PBGC). United's effort to dump its pensions is
being watched closely by the rest of the airline industry, where record high
fuel costs, the lowest fares since the early 1990s and stiff deregulated
competition have caused network carriers to lose billions of dollars. Delta
lost over $1 billion in the first quarter of 2005. A successful move by United
to get out from under its pension obligations, following a similar step taken
successfully by US Airways Group Inc in February, cleared the way for similar
actions elsewhere in the industry and the economy. American Airlines, the
largest US carrier and a unit of AMR Corp, has said it will keep its pension
plans but is concerned about No 2 United gaining a financial advantage with
the elimination of its pension obligations. Pension arbitrage is producing the
same destructive effect on labor as cross-border wage arbitrage.

Detroit, namely Ford and General Motors, with their most profitable models
being the gas-guzzling trucks and sport utility vehicles (SUVs) that can take
more than $100 to fill their tanks, are going down the same route with their
pension obligations. General Motors Acceptance Corp (GMAC), a huge $300
billion credit-finance company, is facing financial problems created by the
falling dollar, rising interest rates, and falling auto sales. GMAC debt, at
about $260 billion, has fallen to junk status. GM's pension fund is
underfunded by $17 billion, at only 80% of its obligations. The prospect of a
private pension collapse is more pressing than the accounting crisis in Social
Security. As Ford and GM fall into financial stress, their extended network of
parts and material suppliers is also falling into insolvency.

The result is that the PBGC will fail financially as more companies default on
their pension obligations, the same away the Federal Deposit Insurance Corp
(FDIC) did during the savings and loan crisis of the 1980s. On September 2,
Labor Day 1974, the landmark Employee Retirement Income Security Act (ERISA)
became law in the US, with the government insuring pensions for millions of
workers. Since then, PBGC has paid more than $8 billion in benefits to
retirees under private-sector-defined benefit pension plans in the agency's
care.

PBGC already administers the retirement benefits of almost 500,000 workers and
retirees who were covered by about 2,700 terminated pension plans. Nearly half
of them worked in five major industries: primary metals; airlines; industrial
machinery; motor vehicles and parts; and rubber and plastics. PBGC insures
more than 44,000 private-sector pension plans covering some 42 million
workers, about one in every three US workers. Before PBGC was created, many
workers labored without assurance of receiving the pensions they earned. In
those not-so-good old days, there were instances where thousands of people
lost all retirement benefits when their companies failed and could not keep
pension commitments. Because of PBGC, this can no longer happen. When business
failures occur and companies can no longer support their defined benefit
pensions, PBGC will pay worker benefits as ERISA provides. But with entire
industries going down the drain, PBGC, an insurance enterprise operating on
the actuary principle of occasional unit default within healthy industries,
cannot shoulder the cost of industrywide defaults without a federal bailout.
Fifty-dollar oil will accelerate this crisis in government pension insurance.

Fact 6: Industrial plastics, the materials most in demand in modern
manufacturing, more than steel or cement, are all derived from oil. Higher
prices of industrial plastics will mean lower wages for workers who assemble
them into products. But even steel and cement require energy to produce and
their prices will also go up along with oil prices. While low Asian wages are
keeping global inflation in check through cross-border wage arbitrage, rising
energy prices are the unrelenting factor behind global inflation that no
interest-rate policy from any central bank can contain. Ironically, from a
central bank's perspective, a commodity-price-pushed asset appreciation, which
central banks do not define as inflation, is the best cure for a debt bubble
that the central banks themselves created.

Fact 7: War-making is a gluttonous oil consumer. With high oil prices,
America's wars will carry a higher price, which will either lead to a higher
federal budget deficit, or lower social spending, or both. This translates
into rising dollar interest rates, which is structurally recessionary for the
globalized economy. But while war is relentlessly inflationary, war spending
is an economic stimulant, at least as long as collateral damage from war
occurs only on foreign soil. War profits are always good for business, and the
need for soldiers reduces unemployment. Fighting for oil faces little popular
opposition at home, even though for the United States the need for oil is not
a credible justification for war. The fact of the matter is that the US
already controls most of the world's oil without war, by virtue of oil being
denominated in dollars that the US can print at will with little penalty.

Fact 8: There is a supply/demand myth that if oil prices rise, they will
attract more exploration for new oil, which will bring prices back down in
time. This was true in the good old days when oil in the ground stayed a
dormant financial asset. But now, as explained by Facts 3 and 4 above, in a
debt bubble, oil in the ground can be more valuable than oil above ground
because it can serve as a monetizable asset through asset-backed securities
(ABS) in the wild, wild world of structured finance (derivatives). So while
there is incentive to find more oil to enlarge the asset base, there is little
incentive to pump it out of the ground merely to keep prices low.

Gasoline prices also will not come down, not because there is a shortage of
crude oil, but because there is a shortage of refinery capacity. The refinery
deficiency is created by the appearance of gas-guzzlers that Detroit pushed on
the consuming public when gasoline was cheaper than bottled water, at less
than a $1 a US gallon (26.5 cents a liter). Refineries are among the most
capital-intensive investments, with nightmarish regulatory hurdles. Refineries
need to be located where the demand for gasoline is, but families that own
three cars do not want to live near a refinery. Thus there is no incentive to
expand refinery capacity to bring gasoline prices down because the return on
new investment will need high gasoline prices to pay for it. After all, the
market is not a charity organization for the promotion of human welfare. It is
a place where investors try to get the highest price for products to repay
their investment with highest profit. It is not the nature of the market to
reduce the price of output from investment so that consumers can drive
gas-guzzling SUVs that burn most of their fuel sitting in traffic jams on
freeways.

Fact 9: According to the US Geological Survey, the Middle East has only half
to one-third of known world oil reserves. There is a large supply of oil
elsewhere in the world that would be available at higher but still
economically viable prices. The idea that only the Middle East has the key to
the world's energy future is flawed and is geopolitically hazardous.

The United States has large proven oil reserves that get larger with rising
oil prices. Proven reserves of oil are generally taken to be those quantities
that geological and engineering information indicates with reasonable
certainty can be recovered in the future from known reservoirs under existing
economic and geological conditions. According to the Energy Information
Administration (EIA), the US had 21.8 trillion barrels of proven oil reserves
as of January 1, 2001, twelfth-highest in the world. These reserves are
concentrated overwhelmingly (more than 80%) in four states - Texas (25%,
including the state's reserves in the Gulf of Mexico), Alaska (24%),
California (21%), and Louisiana (14%, including the state's reserves in the
Gulf of Mexico).

US proven oil reserves had declined by about 20% since 1990, with the largest
single-year decline (1.6 billion barrels) occurring in 1991. But this was due
mostly to the falling price of oil, which shrank proven reserves by
definition. At $50 a barrel, the reserve numbers can expand greatly. The
reason the US imports oil is that importing is cheaper and cleaner than
extracting domestic oil. At a certain price level, the US may find it more
economic to develop domestic oil instead of importing. The idea of achieving
oil independence as a strategy for cheap oil is unworthy of serious
discussion.

And then there are "unconventional" petroleum reserves that include heavy
oils, which can be pumped and refined just like conventional petroleum except
that they are thicker and have more sulfur and heavy-metal contamination,
necessitating more extensive and costly refining. Venezuela's Orinoco
heavy-oil belt is the best-known example of this kind of unconventional
reserves, currently estimated to be 1.2 trillion barrels. Tar sands can be
recovered via surface mining or in-situ collection techniques. This is more
expensive than lifting conventional petroleum but not prohibitively so.
Canada's Athabasca Tar Sands are the best-known example of this kind of
unconventional reserves, currently estimated to be 1.8 trillion barrels. Oil
shale requires extensive processing and consumes large amounts of water.
Still, unconventional reserves far exceed the current supply of conventional
oil.

The economics of petroleum are as important as geology in coming up with
reserve estimates since a proven reserve is one that can be developed
economically. If the Mideast and the Persian Gulf implode geopolitically and
oil from this region stops flowing, the US will be the main beneficiary of $50
oil, or even $100 oil, as would Britain with its North Sea oil and countries
such as Norway and Indonesia. But the big winner will be Russia. For China, it
would be a wash, because China imports energy not for domestic consumption,
but to fuel its growing export machine, and can pass on the added cost to
foreign buyers. In fact, the likelihood of the US bartering below-market Texas
crude for low-cost Chinese manufactured goods is very real possibility in the
future. Similar bilateral arrangements between China-Russia, China-Venezuela
and China-Indonesia are also good prospects.

Fact 10: Fifty-dollar oil will buy the US debt bubble a little more time,
albeit bubbles never last forever. But in a democracy, the White House is
under pressure from a misinformed public to bring the oil price back down to
$25, not realizing that the price for cheap oil can be the bursting of the
debt bubble. Despite all the grandstand warnings about the need to reduce the
US trade deficit, a case can be made that the United States cannot drastically
reduce its trade deficit without paying the price of a sharp recession that
could trigger a global depression.

The Economics of Oil

Since the discovery of petroleum, its economics has never been about cutting a
square deal for the consumer, corporate or individual, let alone the little
guys or the working poor. It has to do with squeezing the most financial value
out of this black gold.

John D Rockefeller consolidated the US oil industry into a monopoly by
eliminating chaotic competition to keep the price high, not to push prices
down. Neo-classical economics views higher prices of consumables as inflation,
but asset appreciation is viewed as growth, not inflation. Since oil is both
an asset and a consumable commodity, neo-classical economics presents a
dilemma for oil economics. The size of oil reserves is exponentially greater
than the annual flow of oil to the market. What is even more fundamental is
that as the flow of oil to the market is reduced, the price of oil goes up,
enlarging proven reserves by definition. Thus while a rise in the market price
of oil adds to inflation, the corresponding rise of the asset value and size
of oil reserves create a wealth effect that more than neutralizes the
inflationary impact of market oil prices. The world should not care about an
added percentage point in inflation if the world's assets would appreciate 17%
as a result, except that when oil is not owned equally among the world's
population, a conflict emerges between consumers and producers.

In fact, on an aggregate basis, cheap oil can have a deflationary impact on
the economy by reducing the wealth effect. For the US economy, since the
United States is a major possessor of oil assets, both on- and offshore, high
oil prices are in the national interest. What we have is not an inflation
problem in rising oil prices, but a pricing problem that distributes unevenly
the benefits and pains of price adjustment among oil owners and oil consumers,
both domestically and internationally.

On March 12, 1999, St Louis Federal Reserve Bank president William Poole said
in a speech that the growth of the US money supply, which was then at more
than 8% when inflation was below 2% annually, was "a source of concern"
because it outpaced the rate of inflation. The M2 money supply had been
growing at an 8.6% annual rate for the previous 52 weeks to keep the economy
from stalling before the 2000 election. The US Federal Reserve was also
watching the rate of inflation, held down mostly by low oil prices.

The Rises and Falls of OPEC

Failure by the Organization of Petroleum Exporting Countries (OPEC) to cut
production at its meeting in November 1998 prompted prices to collapse to a
12-year low of $10.35 a barrel in New York the following month. A combination
of excess production, rising inventories and poor demand for winter heating
fuels pushed prices down. In March 1999, oil prices climbed 17%, going higher
as oil-producing countries, unified by low prices, succeed in cutting output.
Oil prices began making a sharp recovery in the late winter of 1999, rising
from the low teens at the beginning of the year to more than $22 a barrel by
the early autumn, and crossed $30 a barrel in mid-February 2000. A major cause
was production cuts settled upon in March 1999 by OPEC and other major
oil-exporting nations. Poole warned that "we cannot continue to rely on the
decline of oil prices at the pace of the last couple of years". He said
investors who had pushed bond yields to their highest level in six months were
correct in assuming the Fed's next move would be to increase interest rates.
The Fed Open Market Committee (FOMC), when it met on February 2, 1999, had
left the Fed Funds rate (FFR) target at 4.75%. Poole voted in 1998 for the
FOMC to cut the FFR target three times between September and November to 4.75%
when oil was at $12.

Today, with oil at around $48, the FFR target is 3% effective since May 3.
Annualized growth rate for M2 in April 2005 (relative to April 2004) was
4.139%, a fall by more than half of the 1999 growth rate of 8.6%. If the Fed
is really concerned with fighting inflation, $48 oil and a 3% FFR target
simply do not mix, even with a lowered money-supply growth rate. There is
strong evidence that instead of worrying about inflation, the Fed is really
more worried about the debt bubble, which stealth inflation through asset
appreciation can help to deflate with less or no pain.

In July 1993, when the US economy had been growing for more than two years
from M2 growth of over 6%, Fed chairman Alan Greenspan remarked in
congressional testimony that "if the historical relationships between M2 and
nominal income had remained intact, the behavior of M2 in recent years would
have been consistent with an economy in severe contraction". With the M2
growth rate down to 1.44% in July 1993, Greenspan said, "The historical
relationships between money and income, and between money and the price level,
have largely broken down, depriving the aggregates of much of their usefulness
as guides to policy. At least for the time being, M2 has been downgraded as a
reliable indicator of financial conditions in the economy, and no single
variable has yet been identified to take its place."

M2, adjusted for changes in the price level, remains a component of the Index
of Leading Economic Indicators, which some market analysts use to forecast
economic recessions and recoveries. A positive correlation between
money-supply growth and economic growth exists only on inflation-adjusted M2
growth, and only if the new money goes into new investment rather than as debt
to support speculation on rising asset prices. Sustainable economic expansions
are based on real production, not on speculative debt.
In 2004, longer-term interest rates actually declined from their June high of
4.82% to 4.20% at year-end even as short-term rates rose and the money supply
grew at a 5.67% annual rate. This reflected a credit market unconcerned with
long-term inflation despite a sinking US dollar and oil prices rising above
$50 a barrel. The reason is that $50 oil raised asset value at a faster pace
than price inflation of commodities.

In March 2000, OPEC punctured the Greenspan easy-money bubble by reversing the
fall of oil prices. The FOMC was forced to respond to the change in the rate
of inflation, no longer being held down by declines in oil prices. Because the
easy money stimulated only speculation that did not produce any real growth,
the easy-money bubble of 2000 evolved into the current debt-driven asset
bubble. The smart money realized in 2000 that the market's march toward $50
oil was on. And in 2005, $50 oil appears to be giving Greenspan's debt-driven
asset bubble a second life, most of which ended in the real-estate sector. If
oil should fall back to $25 a barrel, the debt-driven asset bubble will pop
with a bang.

Oil is not included in the World Trade Organization (WTO) regime because it is
not a commodity that can be produced at will by any nation, regardless of
efficiency. Oil producers are members of a natural monopoly devoid of open
competition. Yet OPEC is a cartel. As such, it will eventually conflict with
the competition policy thrust of the WTO. Under WTO rules, oil-producing
nations cannot be charged with price-fixing if they intervene to affect market
prices. OPEC, the International Monetary Fund (IMF) and the WTO are among the
most visible international economic organizations. The WTO regime imposes
draconian free-market rules on trade except for oil and currencies, while OPEC
blatantly practices intergovernmental manipulation of oil prices and the IMF
acts as the world's policeman in defense of dollar hegemony. Neo-liberal
economists do not see OPEC and the IMF as trade-restricting monopolies,
arguing that their separate domains of oil and currencies are not part of the
concern of the WTO regime. Concerted government intervention against market
forces in the price of oil and currencies are tolerated in the name of needing
to correct market failures. The fact of the matter is that the term "market"
is a misnomer for oil and currency transactions. These commodities change
hands not in a market, but in an allotment schema arranged from a central
control point in a neo-feudal regime.

A major key to understanding the operation of OPEC is the internal battle for
market share within OPEC by its members, causing aggregate OPEC production to
be higher than what serves even the cartel's overall interest. Discontinuities
in the production of Iraq and Iran were caused by the Iraq-Iran conflicts
between 1980 and 1988. A second discontinuity in 1990 was caused by Iraq's
invasion of Kuwait and the ensuing Gulf War. A third discontinuity occurred
when the US invaded Iraq in 2003. A fourth discontinuity is pending over
Iran's march toward nuclear-power status. As a major oil producer, Iran needs
nuclear power for civilian use as much as coal-producing Newcastle needs oil.
Obviously, other agendas are at work. OPEC was formed in 1960 with five
founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. By the end
of 1971, six other nations had joined the group: Qatar, Indonesia, Libya, the
United Arab Emirates, Algeria and Nigeria. Of these, only Venezuela is
non-Islamic. OPEC emerged as an effective cartel only after the Arab oil
embargo that started on October 19, 1973, and ended on March 18, 1974. During
that period, the price for benchmark Saudi Light increased from $2.59 in
September 1973 to $11.65 six months later in March 1974. Since then, OPEC has
been setting bottom benchmark prices for its various kinds of crude oil in the
world market.

The oil price dipped below $10 after the Asian financial crisis of 1997. By
1984, the effects of seven years of high prices had taken its toll on demand
in the form of more energy-efficient homes and industrial processes, and in
substantial increases in automobile fuel efficiency, not to mention new
competitive use of coal. At the same time, crude-oil production was increasing
throughout the world, stimulated by higher prices. During this period, OPEC
total production stayed relatively constant, around 30 million barrels per
day. However, OPEC's market share was decreased from more than 50% in 1974 to
47% in 1979. The loss of market share was caused by non-OPEC production
increases in the rest of the world. Higher crude prices caused by OPEC
production sacrifices had made exploration more profitable for everyone, not
just OPEC, and many non-OPEC producers around the world rushed to take
advantage of it.

The rapid oil-price increases since 1980 served to accelerate consumer moves
toward energy efficiency. In the US, conservation was also helped by tax
incentives and new regulations. Sharp increases in non-OPEC production fueled
by high oil prices were compounded by the deregulation of domestic crude-oil
prices in the US.

Global demand for oil had peaked by 1979 and it became clear that the only way
for OPEC to maintain prices was to reduce production further. OPEC reduced its
total production by a third during the first half of the 1980s. As a result,
the cartel's share in world oil production dropped below 30%. Non-OPEC
producers got a big lift from higher prices, larger market shares, and an
expanded definition of proven reserves.

Looking at OPEC members' production share within the organization and not
their share of total world production, one could clearly see Saudi Arabia
acting as swing producer for OPEC during the first half of the 1980s in the
cartel's attempt to shore up declining prices. By 1986, the Saudis got tired
of playing this role as other OPEC member countries were cheating on their
quotas at Saudi expense. In response, Saudi Arabia rapidly increased
production, causing a major price collapse. It created an oil boom in
oil-consuming economies and a recession in oil-producing economies. But since
the oil-producing economies were the consumers of the manufactured products
made by the oil-consuming economies, recession in oil-producing economies
caused a worldwide recession, as reflected in the 1987 crash in the US stock
markets.

It took almost three years for oil prices to recover. The lower prices did
have a long-term beneficial effect for OPEC. They encouraged increased
consumption and halted production increases in much of the rest of the world,
causing among other things the oil depression in Texas. By the end of the
decade of the 1980s, prices finally stabilized. Throughout the late '80s,
however, when oil prices plummeted, bankrupt oil drillers dragged Texas banks
under, causing the entire oil-dominated Texas economy to go into convulsion.
Today, in a globalized debt market, if a major borrower goes bust in Texas, it
would only affect dispersed small units of commercial asset-backed security
bonds of unbundled risks held in countless money managers' portfolios all over
the world. The effect would be so diffused that no one would even notice.
Securitization of debt now stands at more than $4 trillion globally, up from
$375 billion in 1985.

OPEC, or any other cartel, faces a problem of optimization in its attempts to
control prices. The problem is to determine the level of production that meets
its collective goals of highest prices with the biggest volume over the
longest sustainable period. For OPEC, this means maintaining production levels
that ensure the highest oil prices possible without encouraging competitive
production outside OPEC or significant conservation measures on the part of
consumers everywhere.

The Saddam Hussein Factor

In January 1990, Saudi Arabia and Kuwait had 24% and 9% of OPEC's total
production. Iraq and Iran had 13% and 12% respectively. Iraq was involved at
this time in a territorial dispute with Kuwait. Negotiations between the two
Arab countries failed to produce any solution. In a meeting on July 25, 1990,
between Iraqi president Saddam Hussein and US ambassador April Glaspie, Saddam
was assured that the US would not become involved in the Arab-to-Arab
political dispute. It was a major factor in Iraq's decision to reincorporate
Kuwait by force. A week later, on August 2, 1990, Iraq invaded and occupied
Kuwait, giving it control of 22% of OPEC production.

The United States, belatedly realizing that political consolidation of Arab
oil was against its long-standing policy of divide and rule, reversed itself
on the basis of defending the principle of state sovereignty, and became the
major force in restoring Kuwait's questionable sovereignty and de facto oil
ownership early in 1991. At this point, the US-engineered embargo prevented
the export of Iraqi oil, and Kuwait's oilfields had been destroyed by war.
Iraq and Kuwait had virtually no production and the slack was taken up by
other OPEC members, primarily Saudi Arabia. In February 1991, Saudi Arabia's
production accounted for more than 35% of OPEC output. The Saudis had
increased production sufficiently to compensate for the loss of Kuwait's
production as well as some of that of Iraq. The Saudis were forced by US
pressure to pay for the cost of the Gulf War and by Arab pressure to provide
financial aid to defeated Iraq under the table, all from the windfall revenue.
Not much was changed in the oil economics of the region except in the
political accounting.

By December 1998, Saudi Arabia's global market share was 29.7%, Kuwait's 7.4%,
Iran's 13.0%, Iraq's 8.4% and Venezuela's 11.0%. Saudi Arabia had the greatest
increase in market share compared with the pre-Gulf War period, although it
had fallen back from its 35% postwar peak, as Kuwait and Iraq recovered.
Venezuela was third, after Iran. In addition, the Saudis have always had the
largest volume of production. At most times, the Saudis produce at least twice
as much as the second-largest OPEC producer. Those who follow OPEC will recall
that, especially in the 1980s, many of the negotiations over production quotas
included discussions of what was equitable for the member countries. Among the
factors considered were population, per capita income and the economic
dependence upon crude-oil exports and, last but not least, economic threats to
political stability.

By the end of the 1980s, most of the issues about the sharing of the total
OPEC production pie had been resolved. But all of the explicit and implicit
agreements in place at that time were disrupted by Iraq's invasion of Kuwait
and the ensuing Gulf War. After the war, OPEC tried to move back toward the
pre-Gulf War agreements on splitting up the production pie and return to the
old method of doing business. Some consideration was given to the economic
needs of OPEC members as well as non-OPEC members with emerging economies,
such as Mexico.

The Hugo Chavez Factor

Venezuela was a case in point. The country was on its economic knees or worse,
victimized by neo-liberal policies of accepting foreign debt secured by oil
exports and driven to the ground by IMF conditionality rescues. Despite the
fact that Venezuela had increased its share of OPEC production significantly
over the previous decade, OPEC declined to demand that Venezuela give up its
gains. OPEC agreed on another cutback in production to boost prices in 1997
without requiring Venezuela to share proportionately in that cut. Yet
Venezuela continued to view oil prices as too low to meet its needs in
servicing foreign debt. OPEC was bending backward in vain to avoid pushing
Venezuela into a left-leaning revolution. There was a lot of pressure from the
US on Saudi Arabia to shoulder a disproportionate share of the cuts after
1997.

Under US pressure, OPEC tolerance changed after Hugo Chavez was elected
president of Venezuela in 1998 with 56% of the vote, and re-elected in 2000
under the new constitution with 59% of the vote. In November 2000, the
National Assembly granted Chavez the right to rule by decree for one year, and
in November 2001, he made a set of 49 decrees, including fundamental reforms
in oil and agrarian policy. In December 2001, the nation's largest business
organizations and the right-dominated Petroleum Workers Union organized a
general strike. In 2002, the US-backed opposition forces staged an
unsuccessful coup that was foiled by a massive popular uprising, with support
from the rank-and-file members of the military. Chavez was restored to the
presidency after 48 hours. A recall referendum, certified by the Organization
of American States and the Carter Center, failed by giving Chavez a 58%
majority.

Chavez' popularity in Venezuela and throughout Latin America, where two-thirds
of the South American continent have elected leftist presidencies, has grown.
As oil prices soared in the wake of the second Iraq war and from booming
Chinese demand, oil-rich Venezuela gained financial power to refuse predatory
loans and aid from the United States, in its struggle to distance itself from
US domination. Washington's influence in Caracas evaporated, as Chavez accused
the administration of US President George W Bush of having staged the failed
2002 coup. A 35-year military agreement between the US and Venezuela was
unilaterally annulled by Venezuela on April 24 this year.

Supply and Demand

Current oil-price levels are a reflection of a fleeting inventory problem
rather than a long-term pricing issue. There is of course no, and has never
has been, a problem with the natural supply of oil. The world will still be
awash with oil even after petroleum is rendered obsolete by new energy
technology. When US president Bill Clinton threatened to release US strategic
reserves in the 1990s, OPEC signaled its decision to increase production
immediately more than once, not because of market fundamentals, but as
political gestures. Many economists think that $35 oil in the long run is good
for the global economy. At any rate, oil is no longer a critical factor for
the US economy, which is increasingly less dependent on oil for growth. GE
announced in February 2000 a new turbine that would be 60% more efficient than
current models in generating electricity for the same energy input. The news
did not help GE stock prices.

There was solid evidence that the 1970s recycling of petrodollars, which
mostly ended up in the dollar assets in the United States anyway, contributed
to US inflation as much as the higher retail price of gasoline. It in essence
siphoned off additional global funds to purchase higher-priced oil for
investment in US real estate, which was the only sector the then
unsophisticated Arab money managers thought they knew enough about to handle.
By the 1990s, they were more sophisticated. Some had expected that a new
injection of petrodollars would sustain the collapsing "new economy" equity
market of the '90s. It did not work because, even at $35, oil was still behind
its pre-1973 price relative to the peak Nasdaq in June 1999, the equivalent of
which would bring $120 oil.

The drop in oil prices after 1997 was mostly a cyclical effect of the drastic
reduction of demand from the Asian financial crisis, which impacted the whole
world. There was zero pressure even in the US to raise oil prices at that
time, because of the effect they had on keeping easy-money inflation low. Even
oil companies were not really upset by this temporary condition because, until
oil prices dropped below $7 per barrel, it was not a big deal since that was
the offshore production cost in the North Sea. The wellhead cost on land was
less than $4 per barrel, plus market-induced leasehold costs. North Sea oil
was higher because of fixed offshore drilling investments. In 1998, oil could
stay at anywhere above $7 for quite a few years without doing any lasting harm
to the US or Europe. It was widely expected to go back up to $35 by the end of
2000, and a lot of people would get rich in the process. OPEC was touting the
line of argument that high prices would stimulate new exploration to get the
non-OPEC consumers to accept costlier oil. In the long run, less new
exploration would be good for OPEC. Before 1973, the whole world was happy
with $3 oil. As for the US, cheap oil kept inflation (as measured by the Fed)
low, the dollar high and dollar interest rates low. These benefits outweighed
the oil-sector problems created by a collapse in oil prices. In oil, no one
has told the truth for more than 80 years, or since its discovery.

There were all kinds of reasons that US president George H W Bush pushed Iraq
out of Kuwait, Clinton bombed Iraq, and Bush Jr invaded and occupied it, but
oil prices were very low on the list and terrorism was not even on the list.
If Iraqi oil re-enters the world market, other OPEC members will reduce the
production quota, so the real impact on prices will be minimum. Most market
analysts have estimated the price movement at less that $1 under such
development. So at the post-1997 price of $10-plus per barrel, only the profit
margin was reduced and some idiotic oil brokers in Chicago holding high
futures contracts, and some high-rolling investors in oil rigs in Texas, got
wiped out, including a future occupant of the White House. But the good news
for the oil industry was that it gave a big boost to oil-company mergers to
consolidate the sector and reserves and downsize employment, which in better
times the US government would have never approved for antitrust reasons.

As Asia recovered from the 1997 financial crisis, lifted mostly by China, the
oil industry found itself in the position to command $50 oil in the next
cycle, and enjoyed the inflated value of its global reserves, which it had
bought up at low cost a decade ago. The low prices of the past decade had also
put OPEC countries, predominantly Islamic, in their places, including the
bonus of Indonesia and Russia, which had to live exclusively on oil exports
(not really living, because all of the reduced revenue went to service foreign
debts assumed in better times). With globalization, the US, the center, has
been enjoying the rotting of the outer limbs of the global economy since the
end of the Cold War, but it has yet to realize gangrene kills the whole
organism.

Iraq was not an oil problem as far as Washington was concerned. In fact, low
oil prices worked against Saddam in the black market. Saddam has been
portrayed by the US as one of its worst enemies. But he has not always worn
and will not always wear that honor, given the unpredictability of Iran. The
terrorist attacks on the US on September 11, 2001, put a new dimension on the
problem of Iraq. The reason the US failed to kill Saddam was not incompetence
or Christian mercy, but the fact that Saddam might not have been the worst
alternative. He was just a bad boy who misbehaved. What Washington wanted was
for Saddam to be its bad boy. Saddam is far from totally finished politically.
The world has seen stranger things than the political rehabilitation of Saddam
Hussein. He has a major advantage over Bush Jr, as he did over Clinton and
Bush Sr. Saddam has a focused purpose whereas Clinton, the Bushes, and US
policy are all driven by complex incentives that are at times contradictory.
The political economy of oil is no intellectual tea party. There is no price
economics in oil. It's all politics of the dirtiest kind.

The Problem With Cheap Oil

It is often overlooked that the United States is a major oil producer. In
fact, before the discovery of oil in the Middle East in the 1930s, the US was
the world's biggest exporter of oil. "Oil for the lamps of China" was a slogan
of the Standard Oil monopoly. It is not clear that cheap oil is in the United
States' national interest. Cheap oil distorts the US economy in unconstructive
ways. In recent years of cheap oil, advances in conservation have all been
abandoned. Until this year, US consumers were buying eight-cylinder SUVs that
deliver only eight miles per gallon (29 liters per 100 kilometers), as well as
air-conditioned convertibles. Even with $2 (53 cents per liter) gasoline,
commuters face only a $500 annual increase in their gas bills. Vehicle prices
have risen faster than gasoline prices in recent decades. Of course, the rest
of the world outside the US has been operating on $4 (more than $1 per liter)
gasoline for a long time.

It is an economic axiom that excessively low commodity pricing breeds abuse of
that commodity. This truth can be observed in water, air, petrochemicals and
energy. It holds true even for labor and capital. Higher labor cost drives
productivity growth. Greenspan's favorite homely is: "Bad loans are made in
good times."

OPEC had been permitted to assume an effective cartel role only at the
pleasure of the United States. The existence of OPEC serves several convenient
US geopolitical purposes. It deflects political opposition to the
international oil regime from the US toward a mostly Arab/Islamic
organization, yet the health of OPEC is inseparably tied to the health of the
energy corporations of the West that control all the downstream operations.
OPEC is an example of how economic nationalism can be co-opted into
Western-dominated neo-imperialist globalization.

Excessively high oil prices are of course as detrimental to an economy as
excessively low oil prices. The last downturn in crude-oil prices had
immediate impacts on the exploration segment of the industry. Coincident with
that was a decline in sales and manufacture of oil and gas equipment. Another
segment of the industry that felt the pressure of the price decline was oil
and gas services.

According to James Williams of WTRG Economics, oil prices behave much as any
other commodity, with wide price swings in times of shortage or oversupply. US
domestic oil prices were heavily regulated through production or price control
throughout much of the 20th century. In the post-World War II era, oil prices
averaged $19.27 per barrel in 1996 dollars. Through the same period, the
median price for crude oil was $15.27 in 1996 prices. That meant that only
half of the time from 1947 to 1997 did oil prices exceed $15.26 per barrel.
Prices only exceeded $22 per barrel in response to war or conflict in the
Middle East. In 1972, $3.50 oil translated to $11.50 in 1996 dollars and
$16.29 in 2005 dollars.

The long-term view is much the same. Since 1869, US crude-oil prices adjusted
for inflation have averaged $18.63 per barrel in 1996 dollars. Fifty percent
of the time, prices were below $14.91. Using long-term history as a guide,
those in the upstream segment of the crude-oil industry structured their
business to be able to operate profitably below $15 per barrel half the time.

Pre-embargo crude-oil prices ranged between $2.50 and $3 from 1948 through the
end of the 1960s. The price of oil rose from $2.50 in 1948 to about $3 in
1957. When viewed in 1996 dollars, an entirely different story emerges. In
1996 dollars, crude-oil prices fluctuated between $14 and $16 during the same
period. The apparent price increases were just keeping up with inflation. From
1958 to 1970, prices were stable at about $3 per barrel, but in real terms the
price of crude oil declined from above $15 to below $12 per barrel in 1996
dollars. The decline in the price of crude when adjusted for inflation was
exacerbated in 1971 and 1972 by the weakness of the US dollar.

Member nations had experienced a decline in the real value of their oil since
the foundation of OPEC. Throughout the post-World War II period, exporting
countries found increasing demand for their crude oil was rewarded by a 40%
decline in the purchasing power in the price of a barrel of crude until March
1971, when the balance of power shifted. That month, the Texas Railroad
Commission set pro ration at 100% for the first time. This meant that Texas
producers were no longer limited in the amount of oil that they could produce.
More important, it meant that the power to control crude-oil prices shifted
from the US cartel (Texas, Oklahoma and Louisiana) to OPEC.

In 1972, the price of crude oil was about $3 and by the end of 1974 had
quadrupled to $12. The Yom Kippur War started on October 5, 1973. The US and
many other Western countries gave strong support to Israel. To punish such
support, Arab oil-exporting nations imposed an embargo on the nations
supporting Israel. Arab nations curtailed production by 5 million barrels per
day. About 1mbpd was made up by increased production of non-Arab/Islamic
producer countries. The net loss of 4mbpd extended through March 1974 and
represented 7% of Western world production. Any doubt that the ability to
control crude-oil prices had passed from the US to OPEC was removed during the
1973 Arab oil embargo. The extreme sensitivity of prices to supply shortages
became all too apparent, though obviously unsustainable over the long term.
Prices increased 400% in six short months. The abrupt jump, not the high price
itself, caused destabilizing damage to the US and other Western economies.

From 1974 to 1978, crude-oil prices increased at a moderate pace from $12 per
barrel to $14, mostly due to adjustments in demand moderated by increases in
alternative sources of supply. When adjusted for inflation, prices were
constant over this period of time. War between Iran and Iraq led to another
ound of increases in 1980. The Iranian revolution resulted in the loss of
2-2.5mbpd between November 1978 and June 1979. Starting in 1980, Iraq's
crude-oil production fell 2.7mbpd and Iran's by 600,000 barrels per day during
the Iran-Iraq War. The combination of these two events resulted in crude-oil
prices more than doubling from $14 in 1978 to $35 per barrel in 1981.

The rapid increase in crude prices in this period would have been much less
were it not for US energy policy. The US imposed price controls on
domestically produced oil in an attempt to lessen the impact of the 1973-74
price increase. The obvious result of the price controls was that US consumers
of crude oil paid 48% more for imports than domestic production, while US
producers received less. In the short term, the recession induced by the
1973-74 price rise was made less painful by oil price control. However, in the
absence of price controls, US exploration and production would certainly have
been significantly greater, counterbalancing the economic decline. The higher
prices faced by consumers would have resulted in still lower rates of
consumption: automobiles would have had higher fuel efficiency sooner, homes
and commercial buildings would have been better insulated and improvements in
industrial energy efficiency would have been greater than they were during
this period, thus cushioning the recession. As a consequence, the US would
have been less dependent on imports in 1979-80 and the price increase in
response to Iranian and Iraqi supply interruptions would have been
significantly less.

OPEC has seldom been effective as a cartel. During the 1979-80 period of
rapidly increasing prices, Saudi Arabia's oil minister, Ahmed Yamani,
repeatedly warned other members of OPEC that high prices would lead to a
reduction in demand. For example, Armand Hammer's Occidental Oil joint venture
with the Chinese Ministry of Coal to export coal-derivative fuel based on $50
oil was bound to head toward financial disaster. The coal project in China
failed by 1986 as oil prices fell.

The rapid price increases caused several reactions among consumers: better
insulation in new homes, increased insulation in many older homes, more energy
efficiency in industrial processes, and automobiles with lower fuel
consumption, all with various forms of government subsidies or tax relief.
These factors along with a global recession caused a reduction in demand that
led to further falling crude prices. Unfortunately for OPEC, while the global
recession was temporary, nobody rushed to remove insulation from their homes
or to replace energy-efficient plants and equipment when the economy
recovered. Much of the consumer reaction to the oil-price increase of the end
of the decade was permanent and would not respond to lower prices with
increased demand for oil.

From 1982 to 1985, OPEC attempted to set production quotas low enough to
stabilize prices. These attempts met with repeated failure as various members
of OPEC continued to produce beyond their quotas. During most of this period,
Saudi Arabia acted as the swing producer cutting its production to stem the
free-falling prices, as it intends to do now to halt the rise in price. In
August 1985, the Saudis, tired of this role, linked their oil prices to the
spot market for crude and by early 1986, increased production from 2mbpd to
5mbpd. Crude-oil prices plummeted below $10 per barrel by mid-year. China had
a new minister of coal that same year.

A December 1986 OPEC price accord set to target $18 per barrel was already
breaking down by the following month. Prices remained weak. The price of crude
oil spiked in 1990 with the uncertainty associated with the Iraqi invasion of
Kuwait and the ensuing Gulf War. Within hours of the first air strike against
Iraq in January 1991, the White House announced that president Bush Sr was
authorizing a drawdown of the Strategic Petroleum Reserve (SPR), and the
International Energy Agency (IEA) activated the plan on January 17. After the
oil crisis of 1973-74, the IEA was created as a cooperative grouping of most
of the member countries of the Organization for Economic Cooperation and
Development, committed to responding swiftly and effectively in future oil
emergencies and to reducing their dependence on oil.

Crude prices plummeted by nearly $10 a barrel in the next-day trading, falling
below $20 for the first time since the Iraqi invasion of Kuwait. The price
drop was attributed to optimistic reports about the allied forces' crippling
of Iraqi air power and the diminished likelihood, despite the outbreak of war,
of further jeopardy to world oil supply; the IEA plan and the SPR drawdown did
not appear to be needed to help settle markets, and there was some criticism
of it. Nonetheless, more than 30 million barrels of SPR oil was put out to
bid, and 17.3 million barrels were sold and delivered in early 1991. But after
the war, crude oil prices entered a steady decline until 1994, when
inflation-adjusted prices attained their lowest level since 1973. The price
cycle then turned up. With a strong economy in the US and a booming economy in
Asia, increased demand led a steady price recovery well into 1997. This came
to a rapid end as the impact of the 1997 financial crisis in Asia was
underestimated by OPEC, being advised by the IMF. That December, OPEC
increased its quotas by 10% to 27.5mbpd, but the rapid growth in Asian
economies had come to a halt and reversed direction by half.

The rotary rig count is the average number of drilling rigs actively exploring
for oil and gas. Drilling an oil or gas well is a high-risk, capital-intensive
investment bet in the expectation of returns from the production of crude oil
or natural gas in an uncertain market. Rig count is one of the primary
measures of the health of the exploration segment of the oil and gas industry.
In a very real sense, it is a measure of the oil and gas industry's confidence
in its own future. At the end of the Arab oil embargo in 1974, rig count was
below 1500. It rose steadily with regulated rise of crude-oil prices to more
than 2000 in 1979. From 1978 to the beginning of 1981 domestic US crude-oil
prices exploded from a combination of the rapid growth in world energy prices
and deregulation of domestic prices. Forecasts of crude prices in excess of
$100 per barrel fueled a drilling frenzy. By 1982, the number of rotary rigs
running had more than doubled.

The peak in drilling occurred more than a year after oil prices had entered a
steep decline that continued until the 1986 price collapse. The one-year lag
between crude prices and rig count disappeared in the price collapse. For the
next few years, towns in the oil patch were characterized by bankruptcies,
bank failures and high unemployment. Investors as far-flung as Hong Kong,
Tokyo, Singapore and London went under with it. Several trends were
established in the wake of the collapse in crude prices. The lag of more than
a year for drilling to respond to crude prices is now reduced to a matter of
months. Like any other industry that goes through hard times, the oil business
emerged smarter and much leaner. Industry participants, bankers and investors
were far more aware of the risk of price movements. Companies long familiar
with accessing geologic risk added price risk to their decision criteria.
Financial hedging came into play in the construction of risk-management
models.

Increased use of three-dimensional seismic data reduced drilling risk.
Directional and horizontal drilling led to improved production in many
reservoirs. Financial instruments were used to limit exposure to price
movements. Increased use of floods to improve production in existing wells
became common. Rig count is certainly a good measure of activity, but it is
not a measure of success. After a well is drilled, it is classified either as
an oil well, a natural gas well or a dry hole. The percentage of wells
completed as oil or gas wells is frequently used as a measure of success,
often referred to as the success rate.

Immediately after World War II, 35% of the wells drilled were dry wells. This
percentage increased to about 43% by the end of the 1960s. It declined
steadily during the 1970s to reach 30% at the end of the decade. This was
followed by a plateau or modest increase through most of the 1980s. Beginning
in 1990 shortly after the harsh lessons of the price collapse, non-completion
rates decreased dramatically to 23%. These rates are closely watched by
investors. Since the percentage completion rates are much lower for the more
risky exploratory wells, a shift in emphasis away from development would be
expected to result in lower overall completion rates. This, however, was not
the case. An examination of completion rates for development and exploratory
wells shows the same general pattern. The decline in dry holes was
price-related. The higher the price, the fewer dry holes.

Some would argue that the periods of decline in successful drillings were a
result of the fact that every year there is less oil to find. If the industry
does not develop better technology and expertise every year, oil and gas
completion rates should naturally decline. However, this does not explain the
periods of increase. The increase of the 1970s was more related to price than
technology. When a well is drilled, the fact that oil or gas is found does not
mean that the well will be completed as a producing well. The determining
factor is price economics (even though oil prices are fundamentally set
politically). If the well can produce enough oil or gas at anticipated prices
to cover the cost of completion and the ongoing production costs, it will be
put into production. Otherwise, it is an economic dry hole even if crude oil
or natural gas is found. The conclusion is that if real prices are increasing,
we can expect a higher percentage of successful wells. Conversely if prices
are declining, the opposite is true. Thus higher prices increase supply,
regardless of natural conditions and technology.

The success-rate increases of the 1990s, however, could not be explained by
higher prices alone. These increases were clearly also the result of improved
technology. The increased use of and improvements in 3-D seismic data analysis
combined with horizontal and directional drilling. Most dramatic was the
improvement in the percentage of exploratory wells completed. In the 1990s
completion rates have soared from 25% to 45%.

Worked-over rig count is a measure of the industry's investment in the
maintenance of oil and gas wells. The Baker-Hughes worked-over rig count
includes rigs involved in pulling production tubing from a well that is 1,500
feet (457 meters) or more in depth. Worked-over rig count is another measure
of the health of the oil and gas industry. Most work-overs are associated with
oil wells. Worked-over rigs are used to pull tubing for repair or replacement
of rods, pumps and tubular goods that are subject to wear and corrosion. A low
level of worked-over activity is particularly worrisome because it is
indicative of deferred maintenance. When operators are in a weak cash
position, work-overs are delayed as long as possible. Worked-over activity
impacts manufacturers of tubing, rods and pumps. Service companies coating
pipe and other tubular goods are heavily affected. This of course leads to
lower supply down the road and higher prices. Higher prices reverse the
process, which ends up with lower prices later. Fifty-dollar oil will keep the
oil sector expanding for some time.

[This article continues below.]