The Dominoes Are About To Fall

Oil has been in the news these past weeks but most of the world has been inattentive to the crisis and very much unaware of the troubles yet to come.  Our media giants are much to blame in that regard although one can hardly blame their ignorance.  The world’s mass of economists were trained in the old keynesian theories made new with added theories that have been accepted as science.  But as much as those who run the economic departments in universities around the world want to believe that they preach science through their complex mathematical models, it will never be so.  Even clinical psychologists aren’t so stupid as to rely on algorithms of higher order complex math to treat complex human behavior as mechanical.  With that said, let us take a look at the world of oil in a nutshell.

The basis of the price of a barrel of oil is supply and demand.  Inflation is a factor over time and drives up both the cost of supply and the price offered.  Inflation constricts demand but only to a point.  America reached its peak production of oil around 1970, after which the production started to decline.  What accelerated that  decline were all of the individual state actions that prohibited offshore drilling, thus artificial limits were placed on supply.  But about 1973 OPEC was formed by foreign countries (Oil Producing and Exporting Countries, or something like that) and led mostly by the Arab countries.  In the thirties, fifties, and sixties (the forties were the world war years) the large oil companies did the exploration, drilling, pipeline and port construction, and all the other infrastructure needed to export oil to the United States and Europe.  The only oil in Europe at the time was located in Romania and south western Russia and after 1940 was captive to either Nazi Germany or Communist Russia (the old USSR).  The largest oil reserves were held by the Arab countries and the second largest oil reserves at the time were American.  Mexico also had significant oil reserves which American oil companies developed only to see the Mexican government confiscate and place into a national company.  Oil was discovered in South America with the bulk of it in Venezuela.  The cost of discovery and capture of oil was the driving factor in the price of a barrel of oil.  Most of the oil refineries were built in America and gasoline exported rather profitably.

There are two ways to raise the price of a commodity, either greater demand or restriction of supply.  OPEC is a cartel designed to raise oil prices by restriction of supply.  Keep in mind that the state government of Texas and Oklahoma, who have been the largest suppliers of oil (think WTI or West Texas crude oil) had controlled the production or oil at the well head, thus creating a sort of cartel of their own.  But most of the Arab oil was transported to several world wide destinations only one of which was America.  And every years the OPEC oil ministers met to consider collectively raising the price of a barrel of oil.  Now make no mistake, some oil is better than others.  The Saudi sweet light crude fetched a higher price per barrel since it needed less refining than the heavy sour crudes that other countries had to offer.  The other development was that pricing was done in what would become known as Petro Dollars.  One could pay with French Francs but the price would be converted into a Petro Dollar amount.  And most currencies were free floating as the gold standard had been abandoned.  But with the ever increasing price in a barrel of oil came the spur for the search for new supplies.  The Oil and Gas fields of the north seas off Scotland and Norway were put into production.  the costs associated with discovery drilling, and transportation were much higher than the Saudi or American costs but by the time that oil came online, the price per barrel was higher than the breakeven cost points.  This added capacity to the world’s oil supply kept a check on the OPEC countries from raising prices too quickly and too high.  Then came the Alaskan crude that added marginally more oil with a greater part of it going to Japan.  Meanwhile the Mexican controlled production had slowed due to the incompetence of the Mexican government in managing its reserves.  The basic maintenance was not kept up and the oil infrastructure was allowed to deteriorate.

Meanwhile, transitions in the political structure of North Africa led to problems of exploration and continued development.  Eventually these problems would be addressed one way or another and production sporadically resume.  West Africa was the bright spot and production has been fairly even.  South America has seen production problems according to various government changes and now the output form Venezuela has fallen due to government policies and lack of skilled maintenance while Brazil has developed great offshore fields.  Oil drilling technology has allowed deep water drilling but that came at higher costs per barrel.  With tar sands and shale oil being developed due to higher prices in oil, more production came online.  But this has proven to be a problem.  The Russian fields and those in nation-states that were once part of the old USSR have added to the world wide supply and threatened OPEC’s dominance.  The greatest development has been the investment in all this new production and that investment came as debt.  Money is very cheap and its costs are being held down artificially by the various central banks in the hope that economic recovery will come about due to the infusions of cheap borrowed money.  Understand this last part for the Arabs have realized this weakness in the rest of the world.

OPEC has dropped the price of oil and expanded its supply so that it may accomplish several items on its agenda.  The speculation that item number one is to destroy the small producers of oil tar sands and shale oil.  Depending on who is doing the exploration and development, many operators may go bankrupt and the larger oil companies will buy them out.  The second item open to speculation is that the Saudis want to punish Russia.  Iran has not played ball with OPEC and the developed nations have tried to isolate it because of its nuclear programs.  Russia has seen fit to intervene on that score.  That whole middle east is aflame with trouble.  Item number three seems to be aimed at the UK and Norway.  With the possibility of new fields in the north seas under consideration, much lower crude prices will bankrupt the oil industry in that region.  There is simply far too much debt world wide for very low crude oil prices not to affect.  This decision by OPEC may well be the first domino that causes the cascade of others to fall.  And lower prices may punish China who has seen fit to meddle in the affairs of Iraq by buying its oil and keeping its oil infrastructure repaired.  Right now ISIS is busy dismantling a refinery in that area of Iraq it occupies and rebuilding a refinery in eastern Syria.  With the Russian economy and currency in free fall (right now Russia is starting to slide into hyperinflation, a state where the people have little or no confidence in their currency and thus will buy anything of value now for trade later) and likely to remain there for the next several months if not years, we can see that the defaults by Russian businesses nd possibly the state will cause widespread financial fallout.

So there you have an explanation in a nutshell.  I know it is rather crude (didn’t mean it to be a pun) but this is the general knowledge and speculation of the situation.  But do your own due diligence, don’t rely on my skimpy explanation.

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