Will a Collapse in Oil Prices Burst the Middle East Bubble?

Last late June 2014, I noted of tremors in the some of the stock markets of major Arab oil producers, the Gulf Cooperation Council (GCC). The GCC is composed of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. 

The key concern then has been on the region’s escalating wars or increase in social instability, compounded by some worries over property bubbles. Apparently the global risk ON environment has been strong enough for speculators to gloss over or ignore these concerns from which their respective stock markets have partially recovered.

But now a new dynamic compounds on the existing predicaments: Collapsing oil prices in the face of the rallying US dollar.

Pardon me but I will have to compress these charts so as not to make my blog size too big.

As example, one would note of the skyrocketing US dollar against the Kuwaiti dinar and Saudi riyal.

The strong US dollar which has been become a broad based phenomenon has usually underscored a risk OFF environment. As I noted back in mid-September:

As a final note on markets, the US dollar index has been firming of late. Since July 1, the US dollar index has been up by 5%!

The basket of the US dollar index consist of the euro (57.6%), the Japanese yen (13.6%),British pound (11.9%), the Canadian loonie (9.1%), the Swedish Krona (4.2%) and the Swiss franc (3.6%).

Their individual charts reveal that the US dollar has been rising broadly and sharply against every single currency in the basket during the past 3 months.

This may have been due to a combination of myriad complex factors: ECB’s QE, expectations for the Bank of Japan to further ease, Scotland’s coming independence referendum, or expectations for the US Federal Reserve to raise rates in 1H 2015 (this has led to a sudden surge in yields of US treasuries last week), escalating Russian-US proxy war in Ukraine and now in Syria (as US Obama has authorized airstrikes against anti-Assad rebels associated with ISIS, but who knows if US will bomb both the Syrian government and the rebels?) more signs of a China slowdown and more.

Yet a rising US dollar has usually been associated with de-risking or a risk OFF environment. Last June 2013’s taper tantrum incident should serve an example.

So the strong US dollar contributed to last night’s hammering of the US West Intermediate Crude (WTI-lower left) which dived by 3.18% and Europe’s Brent (lower right) which crashed by 4.33%. Yesterday's sharp cascade has been part of the recent downhill trend of oil prices.

The Zero Hedge notes that “WTI has just hit the most oversold levels since Lehman” and “what is gong on with Brent turned out to be far worse, and as the weekly RSI indicator shows the selloff in Brent is now the worst, well, ever!” (bold original)

Some will argue that this should help consumption which subsequently implies a boost on “growth”, but I wouldn’t bet on it. 

Current events don’t seem to manifest a problem of oversupply. To the contrary current developments in the oil markets seem to signify a problem of shrinking global liquidity and slowing economic demand whose deadly cocktail mix has been to spur the incipient phase of asset deflation (bubble bust)

Others argue that this could part of an alleged “predatory pricing” scheme designed as foreign policy tool engaged by some of major oil producers to strike at Russia, Iran or even against Shale gas producers in the US. 

This would hardly be a convincing case since doing so would mean to inflict harm on the oil producers themselves in order to promote a flimsy case of “market share” or to “punish” other governments.

Say Shale oil. There are LOTS more at stake for welfare states of OPEC-GCC nations than are from the private sector shale operators (mostly US). Shale operators may close operations or defer investments until prices rise again. There could also be new operators who could pick up the slack from existing “troubled” Shale oil and gas operators. Such aren’t choices available for oil dependent welfare governments of oil producing nations. As one would note from the above table from Wall Street Journal, at current prices only Kuwait, the UAE and Qatar remains as oil producers with marginal surpluses.

And a shortfall from oil revenues means to dip on reserves to finance public spending. And once these resources drain out from a prolonged oil price slump, the risks of a regional Arab Spring looms.

And the heightened risk of Arab Springs would further complicate the region’s social climate tinderbox. Add to this the economic impact from a weak oil prices-strong dollar, regional malinvestments would compound on the region’s fragility.

Thus, the adaption of "predatory pricing" supposedly aimed at punishing other governments would only aggravate the region’s already dire conditions that risks a widespread unraveling towards total regional chaos.

Two wrongs don’t make a right.

While I don’t expect politicians to be “smart”, their self-interests in maintaining power would hardly let them be dismissive of the welfare state which has been the source of their current political privilege.

As a side note, the region’s complex and deteriorating conditions can be seen in the following developments: Despite aerial bombing by Allied forces, Sunni Islam militants the ISIS has reportedly taken control of much of Western Iraq and has been closing in fast on Baghdad This is aside from advances by the ISIS on the Syrian Kurdish town of Kobani on the Syrian-Turkish border which has reportedly “threatened” to destabilize Turkey

Meanwhile Russia has dipped into $6 billion from its reserve to support her currency the ruble afflicted by sanctions, capital flight and collapsing oil prices. So crumbling oil prices are having a broad based effect on the oil revenue dependent welfare state even from the non-GCC nations.

And as one can see, the GCC has long depended on a weak dollar (easy money) environment. This appears to have now reversed, thus exposing their internal structural fragilities from unsustainable economic bubbles and the welfare state as well as tenuous regional and geopolitical relationships.

This brings us back to the stock markets. There has been renewed signs of stock market tremors among GCC states.

Bahrain’s All Share index appears to be in a topping process, so as with Kuwait Stock Exchange Index whose rally from the Apr-June meltdown appears to have winded down.

Meanwhile Oman’s Muscat index experienced a waterfall as Qatar Exchange Index seems least affected among the GCC, nonetheless has exhibited signs of innate weakness.

Both equity benchmarks of Saudi and UAE crashed 6.5% early this week.

Saudi Arabia’s Tadawul index was hardly affected by the April-June meltdown but the weak oil price-strong US dollar dynamic seems to have permeated to the second largest oil producer (after the US). 

Meanwhile like Kuwait, the seeming recovery of UAE’s Dubai Financial General from the collapse a quarter back seems to have faded. 

Unlike the April-June episode, GCCs stock markets appear to be in unison in signaling a downturn.

I’d say that this serves as reinforcing signs of the periphery to the core dynamics in motion.

Will the current weakness deepen? Or will this just be another cyclical dip? We’ll see.

Iraq War: Dick Cheney’s predictions come true

Mises Academy director Daniel Sanchez at the lewrockwell.com evaluates the predictions of former US VP Dick Cheney

In a 1994 interview, Cheney was taken to task over this “missed opportunity” by the neocon American Enterprise Institute. Cheney defended the decision using the following predictions:

Once you got to Iraq and took it over, took down Saddam Hussein’s government, then what are you going to put in its place? That’s a very volatile part of the world, and if you take down the central government of Iraq, you could very easily end up seeing pieces of Iraq fly off: part of it, the Syrians would like to have to the west, part of it — eastern Iraq — the Iranians would like to claim, they fought over it for eight years. In the north you’ve got the Kurds, and if the Kurds spin loose and join with the Kurds in Turkey, then you threaten the territorial integrity of Turkey.

Let’s look at the events of this past week, and see how clear Cheney’s crystal ball was.

Cheney predicted Syrians taking over western Iraq. Western Iraq, including oil-rich Mosul (the second-largest city in the country), has indeed been taken over by a force entering from Syria: namely, ISIS (the Islamic State of Iraq and Syria), an Al Qaeda splinter group (and beneficiary of American military aid to the rebel forces in the Syrian civil war). True, it’s not the Syrian state, and only partially consists of Syrian people. But he got the geography right, and the demographics partially right. 

Check.

Cheney predicted the Iranians taking eastern Iraq. The U.S. war that overthrew Saddam’s Sunni Muslim regime put the government and the capital in the east, Baghdad, into the hands of a Shi’ite regime allied with Shi’ite Iran, who backed the election of the current prime minister. And now Iran has actually deployed troops to combat ISIS into Iraq from the east. With the U.S. ground presence already mostly gone, and now rapidly evacuating, and Iraqi government soldiers stripping off their uniforms and abandoning their U.S.-supplied weapons to ISIS at the first sight of them, the Iranian troops are becoming the only serious ground force in the east.

Check. 

Finally, Cheney predicted the Kurds spinning loose and being a threat in the north. The Kurds have indeed become autonomous, and recently seized the northern city of Kirkuk for themselves, after it was abandoned by Iraqi government forces fleeing the oncoming ISIS forces.

Check. That’s 3 for 3. 

Pls read the rest here

Russia’s Interventions in Crimea: The Geopolitics of Oil Prices

Global politics are a complex dynamic.

I previously noted that Russia’s response to the Ukraine’s political crisis may have been a pushback on what the former’s political leaders see as “encirclement strategy” (Russia’s government doesn’t want to see US-NATO troops on her door steps). This via indirect interventions by the US on the latter’s affair.

But there seems to be another angle: the actions of the Russian government could have been meant to keep oil prices up. As the prolific fund manager Louis-Vincent Gave of Gavekal.com sums up “when the oil price is high, Russia is strong; when the oil price is weak, Russia is weak”

Mr. Gave writes [www.gavekal.com, hat tip John Mauldin, with Mr. Gave’s permission, Thanks Louis] (bold mine, italics original):

Nineteenth century statesman Lord Palmerston famously said that “nations have no permanent friends or allies, they only have permanent interests.” As anyone who has ever opened a history book knows, Russia’s permanent interest has always been access to warm-water seaports. So perhaps we can just reduce the current showdown over Crimea to this very simple truth: there is no way Russia will ever let go of Sevastopol again. And aside from the historical importance of Crimea (Russia did fight France, England and Turkey 160 years ago to claim its stake on the Crimean peninsula), there are two potential reasons for Russia to risk everything in order to hold on to a warm seaport. Let us call the first explanation “reasoned paranoia,” the other “devilish Machiavellianism.”

Reasoned paranoia

Put yourself in Russian shoes for a brief instant: over the past two centuries, Russia has had to fight back invasions from France (led by Napoleon in 1812), an alliance including France, England and Turkey (Crimean War in the 1850s), and Germany in both world wars. Why does this matter? Because when one looks at a map of the world today, there really is only one empire that continues to gobble up territory all along its borders, insists on a common set of values with little discussion (removal of death penalty, acceptance of alternative lifestyles and multi- culturalism...), centralizes economic and political decisions away from local populations, etc. And that empire may be based in Brussels, but it is fundamentally run by Germans and Frenchmen (Belgians have a hard enough time running their own country). More importantly, that empire is coming ever closer to Russia’s borders.

Of course, the European Union’s enlargement on its own could be presented as primarily an economic enterprise, designed mainly to raise living standards in central and eastern Europe, and even to increase the potential of Russia’s neighbors as trading partners. However, this is not how most of the EU leaders themselves view the exercise; instead the EU project is defined as being first political, then economic. Worse yet in Russian eyes, the combination of the EU and NATO expansion, which is what we have broadly seen (with US recently sending fighter jets to Poland and a Baltic state) is a very different proposition, for there is nothing economic about NATO enlargement!

For Russia, how can the EU-NATO continuous eastward expansion not be seen as an unstoppable politico-military juggernaut, advancing relentlessly towards Russia’s borders and swallowing up all intervening countries, with the unique and critical exception of Russia itself? From Moscow, this eastward expansion can become hard to distinguish from previous encroachments by French and German leaders whose intentions may have been less benign than those of the present Western leaders, but whose supposedly “civilizing” missions were just as strong. Throw on top of that the debate/bashing of Russia over gay rights, the less than favorable coverage of its very expensive Olympic party, the glorification in the Western media of Pussy Riot, the confiscation of Russian assets in Cyprus ... and one can see why Russia may feel a little paranoid today when it comes to the EU. The Russians can probably relate to Joseph Heller’s line from Catch-22:“Ju st because you're paranoid doesn't mean they aren't after you.” 

Devilish Machiavellianism

Moving away from Russia’s paranoia and returning to Russia’s permanent interests, we should probably remind ourselves of the following when looking at recent developments: 1) Vladimir Putin is an ex-KGB officer and deeply nationalistic, 2) Putin is very aware of Russia’s long-term interests, 3) when the oil price is high, Russia is strong; when the oil price is weak, Russia is weak. 

It is perhaps this latter point that matters the most for, away from newspapers headlines and the daily grind of most of our readers, World War IV has already started in earnest (if we assume that the Cold War was World War III). And the reason few of us have noticed that World War IV has started is that this war pits the Sunnis against the Shias, and most of our readers are neither. Of course, the reason we should care (beyond the harrowing tales of human suffering coming in the conflicted areas), and the reason that Russia has a particular bone in this fight, is obvious enough: oil. 

Indeed, in the Sunni-Shia fight that we see today in Syria, Lebanon, Iraq and elsewhere, the Sunnis control the purse strings (thanks mostly to the Saudi and Kuwaiti oil fields) while the Shias control the population. And this is where things get potentially interesting for Russia. Indeed, a quick look at a map of the Middle East shows that a) the Saudi oil fields are sitting primarily in areas populated by the minority Shias, who have seen very little, if any, of the benefits of the exploitation of oil and b) the same can be said of Bahrain, where the population is majority Shia.

Now of course, Iran has for decades tried to infiltrate/destabilize Shia Bahrain and the Shia parts of Saudi Arabia, though so far, the Saudis (thanks in part to US military technology) have done a very decent job of holding their own backyard. But could this change over the coming years? Could the civil war currently tearing apart large sections of the Middle East get worse?

At the very least, Putin has to plan for such a possibility which, let’s face it, would very much play to Russia’s long-term interests. Indeed, a greater clash between Iran and Saudi Arabia would probably see oil rise to US$200/barrel. Europe, as well as China and Japan, would become even more dependent on Russian energy exports. In both financial terms and geo-political terms, this would be a terrific outcome for Russia.

It would be such a good outcome that the temptation to keep things going (through weapon sales) would be overwhelming. This is all the more so since the Sunnis in the Middle East have really been no friends to the Russians, financing the rebellions in Chechnya, Dagestan, etc. So having the opportunity to say “payback’s a bitch” must be tempting for Putin who, from Assad to the Iranians, is clearly throwing Russia’s lot in with the Shias. Of course, for Russia to be relevant, and hope to influence the Sunni-Shia conflict, Russia needs to have the ability to sell, and deliver weapons. And for that, one needs ships and a port. Ergo, the importance of Sevastopol, and the importance of Russia’s Syrian port (Tartus, sitting pretty much across from Cyprus).

The questions raised

The above brings us to the current Western perception of the Ukrainian crisis. Most of the people we speak to see the crisis as troublesome because it may lead to restlessness amongst the Russian minorities scattered across Eastern Europe and Central Asia, and tempt further border encroachments across a region that remains highly unstable. This is of course a perfectly valid fear, though it must be noted that, throughout history, there have been few constants to the inhabitants of the Kremlin (or of the Winter Palace before then). But nonetheless, one could count on Russia’s elite to:

a) Care deeply about maintaining access to warm-water seaports and

b) Care little for the welfare of the average Russian

So, it therefore seems likely that the fact that Russia is eager to redraw the borders around Crimea has more to do with the former than the latter. And that the Crimean incident does not mean that Putin will try and absorb Russian minorities into a “Greater Russia” wherever those minorities may be. The bigger question is that having secured Russia’s access to Sevastopol, and Tartus, will Russia use these ports to influence the Shia-Sunni conflict directly, and the oil price indirectly?

After all, with oil production in the US re-accelerating, with Iran potentially foregoing its membership in the “Axis of Evil,” with GDP growth slowing dramatically in emerging markets, with either Libya or Iraq potentially coming back on stream at some point in the future, with Japan set to restart its nukes ... the logical destination for oil prices would be to follow most other commodities and head lower. But that would not be in the Russian interest for the one lesson Putin most certainly drew from the late 1990s was that a high oil price equates to a strong Russia, and vice-versa.

And so, with President Obama attempting to redefine the US role in the region away from being the Sunnis’ protector, and mend fences with Shias, Russia may be seeing an opportunity to influence events in the Middle East more than she has done in the past. In that regard, the Crimean annexation may announce the next wave of Sunni-Shia conflict in the Middle East, and the next wave of orders for French-manufactured weapons (as the US has broadly started to disengage itself, France has been the only G8 country basically stepping up to fight in the Saudi corner ... a stance that should soon be rewarded with a €2.7bn contract for Crotale missiles produced by Thales and a €2.4bn contract for Airbus to undertake Saudi’s border surveillance). And, finally, the Crimean annexation may announce the next gap higher in oil prices.

In short, buying a straddle option position on oil makes a lot of sense. On the one hand, if the Saudis and the US want to punish Russia for its destabilizing actions, then the way to do it will be to join forces (even if Saudi-US relations are at a nadir right now) and crush the oil price. Alternatively, if the US leadership remains haphazard and continues to broadly disengage from the greater Middle East, then Russia will advance, provide weapons and intelligence to the Shias, and the unfolding Sunni- Shia war will accelerate, potentially leading to a gap higher in oil prices. One scenario is very bullish for risk assets, the other is very bearish! Investors who believe that the US State Department has the situation under control should plan for the former. Investors who fear that Putin’s Machiavellianism will carry the day should plan for the latter (e.g., buy out-of-the-money calls on oil, French defense stocks, Russian oil stocks).

My thoughts 

The above chart from Daily Reckoning which I earlier pointed out represents oil prices required to maintain welfare states of many top oil producing countries (based on 2012). This should much higher today. So if the US-Saudi consortium will punish Russia by way of forcing down oil prices then many of these oil welfare states will incur financing problems that may lead not only to bigger fiscal issues but also to another wave of internal political upheavals or “Arab Spring” 2.0. This may lead to oil supply disruptions and higher prices.

And since Saudi Arabia’s breakeven may be at $80 per bbl, then a dramatic drop in oil prices seem not to be in the interest of Saudi.

On the other hand, Mid-East wars and the risks of its escalation that will cause a spike in oil prices or an “oil shock” will likely spur more economic and political uncertainties. This should also bring forth stagflation which means soaring interest rates that may prick global debt bubbles.

And as previously noted “oil shocks” have been linked with recessions.

University of California economic professor James Hamilton argues that an “oil shock” played a substantial role in the recession of 2008. Mr. Hamilton further noted that high oil prices had been linked with 11 of the 12 post World War II recessions.

So current developments in Crimea may extrapolate to a deeper conundrum for global financial markets and world economies.

Saudi Arabia Cuts Ties with the US over Syria-Iran

After the US government has been forced by the public, aided by Russian President Vladmir Putin’s appeal, to stand down against attacking Syria,  Saudi Arabia reportedly severed ties with the US.

Writes the Daily Mail, (hat tip Mises Blog)

Upset at President Barack Obama's policies on Iran and Syria, members of Saudi Arabia's ruling family are threatening a rift with the United States that could take the alliance between Washington and the kingdom to its lowest point in years.

Saudi Arabia's intelligence chief is vowing that the kingdom will make a 'major shift' in relations with the United States to protest perceived American inaction over Syria's civil war as well as recent U.S. overtures to Iran, a source close to Saudi policy said on Tuesday.

Prince Bandar bin Sultan told European diplomats that the United States had failed to act effectively against Syrian President Bashar al-Assad and the Israeli-Palestinian conflict, was growing closer to Tehran, and had failed to back Saudi support for Bahrain when it crushed an anti-government revolt in 2011, the source said.

'The shift away from the U.S. is a major one,' the source close to Saudi policy said. 'Saudi doesn't want to find itself any longer in a situation where it is dependent.'

It was not immediately clear whether the reported statements by Prince Bandar, who was the Saudi ambassador to Washington for 22 years, had the full backing of King Abdullah.

The growing breach between the United States and Saudi Arabia was also on display in Washington, where another senior Saudi prince criticized Obama's Middle East policies, accusing him of 'dithering' on Syria and Israeli-Palestinian peace.

A US attack on Syria means a likely involvement of Iran which the Saudi leadership also desires the US to go to war with.

Syria and Iran signed a defense pact in 2006 “for military cooperation against what they called the "common threats" presented by Israel and the United States” (Wikipedia)

Aside from the Syrian stand down, Iran seem to be warming up to the US to improve diplomatic relations. Both parties including intermediaries have reportedly been conducting talks for the lifting of economic sanctions against Iran. This further got the goat of the Saudi leadership. 

The prospect of Mideast peace has influenced oil prices. WTIC oil has been on a downward trek.

Yet falling oil prices also imperils the welfare state of many Mideast political economies as previously discussed. 

Latest estimates suggest that Saudi’s budget has been equivalent to $64-67 bbl oil

And high oil prices to keep the welfare state afloat could also be one reason why Saudi’s leadership demands the US to take on Iran.

As a side note, Iran has higher oil price requirements for her welfare state, but obviously economic sanctions poses as a bigger danger or threat. For instance, Iran experienced an episode of hyperinflation in about a year ago

And since the Shale oil revolution, the US has been least dependent on oil imports. In fact, US oil production has surpassed Saudi last April, according to Professor Mark Perry.

This also means lesser influence by Saudi on American foreign policy, which may also have irked the Saudi political leadership

But aside from the geopolitics of oil, the other aspect of Saudi’s demand for the US to go to war with Syria-Iran may have been about regional power

As historian Eric Margolis explains:

But what will happen if punishing US-engineered sanctions against Iran are eased? Oil-rich Iran will rebuild its ravaged economy and infrastructure, and quietly enhance its military power. A key priority for Tehran will be modernizing its decrepit civilian air fleet that routinely crashes from mechanical problems or pilot error. Good news for Boeing and Airbus, as well as US energy companies.

If Iran regains its former role as a major Mideast power, this important development will run head-on into current US strategy to keep it weak and isolated until a pro-US government comes to power in Tehran. A strengthening Iran will generate fear and anxiety in Saudi Arabia and some of the less flexible Gulf states, and increase Tehran’s influence over Iraq.

An Iran with the capability of producing a few nuclear weapons within a year also deeply alarms Washington, its Arab allies, and Israel. An Iran with even a few nukes, like North Korea, would sharply limit US Mideast power and its ability to use military forces against Iran.

Israel knows that Iran has no intention of launching a nuclear attack on the Jewish state, which is a major world nuclear power with an invulnerable triad of land, sea and air-launched nuclear weapons.

But Israel’s constant alarms about Iran’s so far non-existent nuclear weapons serves to distract attention from its rapid absorption of the West Bank and Golan, and generate potent political and financial support from its North American partisans. Or maybe Israel’s leader, Benyamin Netanyahu has actually come to believe his own Jeremiads about Tehran’s supposed suicidal “mad mullahs.”

Today, Israel has no serious enemies in the Arab world: Egypt has been bought off; Iraq and Syria destroyed. Saudi Arabia is in secret alliance with Israel. The only nation that can hope to challenge Israel’s increasingly dominant role in the Mideast is Iran. That puts Israel, Iran and Saudi Arabia in a three-way competition for regional hegemony.

Mideast politics is surely a complicated one.