May 28, 2007 – On January 23rd, at the Underground Investor, I wrote this:
Steve Forbes, publisher of the noted Forbes wealth magazine, went on record at the Las Vegas Gold Show that oil prices would reach $35 a barrel in 2006. That certainly was a contrarian viewpoint at the time, and obviously, it never happened. Although I saw no less than 5 headlines in major financial publications at the beginning of this year that stated $40 oil was inevitable and some that even called for $30 oil as inevitable, I stated “I don’t think oil will go much below $50 even though it is descending right to the verge of $50 and many are stating that $40 oil is a given now.”
This wasn’t the only time I stated that oil was heading higher from January either even as investment newsletters and experts screamed at the time that oil was definitely heading to $40 a barrel and most likely $30 a barrel. Most people, including you, probably have long forgotten those predictions from only several months back, and the investment newsletters that made these predictions thank you for forgetting their predictions as well. But here is something that I’ve been stating for over a year now as well though most people, including prominent investors, have yet to grasp this. You just can’t study finance and expect to be a successful investor. You must understand politics as well.
Even with a cursory review of the oil industry back in January there were political reasons why I was confident that oil was heading higher from January instead of continuing its slide downward as many oil analysts predicted at the time. The reason, quite simply was the inevitable continued weakness of the U.S. dollar, though in the limited space of my standard blog entry, I’ll explain slightly further what I mean. While behind the scenes, the U.S. government no doubt was striking secretive deals to ensure that OPEC would continue selling oil mostly in U.S. dollars and not convert to massive petroEuro sales. If OPEC was going to agree to keep accepting rapidly weakening dollars as payment for their oil, I’m guessing that they were compensated for agreeing to do so with an allowance to set higher oil prices.
Trust me, if the dollar was strong, oil prices (and possibly gas prices too) would not be nearly as high as they are now.
Sure, I’ve heard the arguments made by rose-tinted glasses-wearing oil analysts that traders in oil futures now drive prices and that OPEC has very little control in setting oil prices in today’s markets. However, if some official industry spokesperson has not spoon fed an official “line” for analysts to incorporate into their analysis, the great majority will fail to grasp the meaning of anything outside of the official stance. And yes, I understand that many factors besides OPEC’s production rate such as short term crimps in supply and geo-political concerns cause oil futures to significantly fluctuate in the short term. Yet, I believe that various political interests have their hand in the pot enough to drive the price of oil up or down in the long term depending on the agreements they strike among themselves to serve their purposes.
Today, the first monkeywrench thrown into today’s oil price equation is Kuwait’s recent action to unpeg its local currency, the Kuwaiti dinar, from the U.S. dollar. This certainly is a vote for a belief that the U.S. dollar will continue to fall in strength long term. The real question at stake is this: Will Kuwait’s neighbors, specifically Saudi Arabia, the UAE, and Oman follow? Iran is already there, but will other countries supposedly friendly to U.S. interests follow suit? Although Kuwait’s neighbors were quick to issue statements that they will not follow Kuwait in unpegging their currencies from the dollar, I would not place a huge bet on these statements as governments often say one thing and then just months later, do the exact opposite of what they promise.
After all, most finance ministers from Middle Eastern countries have been quite open about their desire to significantly increase their central banks’ reserve levels of gold, strategies that are more aligned with an eventual unpegging of their local currencies from the U.S. dollar than a continuing peg. If other Middle Eastern countries unpeg their local currencies from the dollar, look for oil prices in America to start falling as the U.S. will have less reason to keep prices artificially high to keep their Middle Eastern partners happy.
That said, the above equation is never as simple as it might appear on the surface. Many of the wealthiest oil-rich Middle Eastern countries depend upon the U.S. military for security so such a move to decouple their currencies from the U.S. dollar could be countered with a threat to cut off any military protection in the future. Furthermore, although all of the media’s attention is squarely focused on China’s actions regarding its dollar denominated reserves today, the Middle East’s actions are just as important as China’s. The only reason the media doesn’t speak of the massive petrodollar reserves of the Middle East is because the bulk of these reserves are often allocated not to Central Bank reserves but to secretive and independently managed investment authorities. In the UAE, the Abu Dhabi Investment Authority, not the UAE central bank, determines how the bulk of petrodollar reserves are spent. Saudi and Kuwait also maintain separate investment authorities which often manage sums 20 times greater than the amount of reserves managed by their central banks.
These Middle Eastern investment authorities don’t publicly relay any information about their holdings either, so the media just ignores them as if they don’t exist. Trust me, the U.S. government has been drilling these investment authorities as to how they are spending their petrodollars and most likely ensuring that many of these petrodollars are re-invested in the U.S. economy as part of the deal to set higher oil prices in the United States. So for now, this shell game is all good. The U.S. charges abnormally high oil prices, Middle Eastern countries make a killing on petrodollar profits, and in turn the U.S. encourages them as part of the deal to invest much of it back into U.S. stock markets which keeps markets rising. Everybody’s happy right? Right, but only so long as everyone that contributes to the oil price equation stays in line. Kuwait is the first to step out of line.
Although many people will blow off Kuwait’s actions and not attach as much significance to Kuwait’s actions as they would if Saudi Arabia had been the perpetrator, Kuwait’s decision to uncouple its currency from the U.S. dollar IS significant for a number of reasons. Number one, when Iraq under Saddam’s leadership invaded Kuwait in August, 1990 in an effort to take control over disputed oil reserves, the U.S. military came to Kuwait’s rescue. Despite this, Kuwait made a decision to counter rising inflation in its country by decoupling its currency from the anemic U.S. dollar. Inflation has been raging in other Middle Eastern countries as well due to rapid economic development and the continuing peg of local currency to the falling dollar. Some of these countries will soon also have to make the difficult decision of continuing to be a “good soldier” in the oil price equation or to stray from the official stance as Kuwait did to tackle more pressing domestic economic issues.
So again, to get to $30 oil, it’s not just a matter of supply and demand and Peak Oil Theories as the media reports, it’s about politics most of all. Even when UAE finance minister Sultan bin Nasser Al Suwaidi stirs the gold market with comments that the UAE will convert 10% of their Central Bank reserves into gold, the more important factor is not the planned $2.5 billion purchase of gold for their Central Bank but this. What if the Abu Dahbi Investment Authority follows suit with a 10% purchase of gold from their estimated 500 billion dollar pool of money? How would such a political move affect their relations with the U.S. and the future price of oil?
Finally, the price of oil has much larger implications for the U.S. economy as inflation indexes drive U.S. Federal Reserve decisions about interest rates, which in turn drives the behavior of the economy and stock market. Although the Federal Reserve continues to successfully dupe the American public about real inflation by reporting a “core” inflation that excludes the cost of energy and uses an inaccurate manipulative method of weighting components to manufacture inflation levels to their desired levels, I do believe that they calculate true inflation levels that they don’t release to the public so that they can make their decisions based upon real figures. If real inflation in the U.S. keeps increasing, then this may spur the U.S. government to renegotiate the terms of their oil purchases from OPEC nations as well. In conclusion the price of oil has many more moving parts than just supply and demand and frenzied predictions of Peak Oil.
[tags]peak oil, OPEC, politics and stocks, dollar crisis[/tags]
