Plunging Crude Oil is a geopolitical time bomb

Your responses are still in pouring in from last week’s “Return of FDR” series. Many of them are excellent. We’ll look at those -- and take a hard look at the dollar and gold, as promised -- on Wednesday.

But today I want to talk about a situation that feels like a ticking time bomb -- a time bomb that could go off sooner rather than later.After climbing to nearly $150 a barrel earlier this year, the price of crude oil has fallen. A lot.

Crude’s big drop is good news for consumers, who won’t have to spend as much on gas and groceries. US prices at the pump recently fell ten cents to $2.92 a gallon, according to the AAA auto club. When the cost of fuel falls, the cost of transported goods falls too.

It’s also good news for the Federal Reserve. Thanks to falling oil prices -- and falling commodity prices in general -- the Fed doesn’t have to worry as much about inflation these days. They can flood the system with paper money to their heart’s content, knowing that the “early warning system” of rising commodity prices has been shut down. (At least for now.)

Big Trouble for the Petrocrats

In sharp contrast, falling oil is very bad news for men like Vladimir Putin and Hugo Chavez. You could even say it’s a flat-out disaster.

One or both of these men may have to take drastic measures in the only way they know how... and they may have to do it soon.

First a little explanation: As you likely know, these “petrocrats” were huge beneficiaries of the oil price run-up. Both had the good fortune of timing their political rise to a period of fast-rising oil wealth.

In Russia, Vladimir Putin amassed vast amounts of power, money and prestige as crude climbed to great heights. In Venezuela, Hugo Chavez used his gusher of funds to bribe the citizenry and spread influence throughout Latin America.

But that was then, and this is now. With the price of crude nearly cut in half from its 2008 highs, the roof is caving in on both men’s heads.

Evaporating Oligarchs

We’ll take a quick look at Russia first.

Though Putin has become extremely popular with average Russians, his real power base is concentrated with the oligarchs and the siloviki.

The oligarchs are Russia’s new class of billionaires -- men who amassed great power and wealth in the chaos and turmoil of Yeltsin’s Russia in the 1990s. The siloviki (a Russian term) are the kingmakers and the lever pullers... the men in the shadows who decide Russia’s fate.

The two groups are deeply intertwined. The oligarchs have the money... the siloviki have the power... and Putin holds court over both.

Now, as the price of crude declines, the oligarchs’ fortunes are falling apart. As the New York Times observes, “perhaps no community of the super affluent has fallen as hard, or as fast, as the brash Kremlin-connected insiders whose wealth was tied up in the overlapping bubbles of the Russian stock market, commodity prices and easy credit.”

The numbers are staggering. Bloomberg calculates that the top oligarchs -- the 25 richest Russians on the planet -- have lost a collective $230 billion over the course of the recent market decline. (This is partly due, too, to a Russian stock market crash. Russia’s benchmark stock index, the RTS index, is down more than 70%.)

Too Much Leverage, Comrade

To make matters worse, many of the oligarchs ran their affairs as if they were one-man investment banks. Huge quantities of leverage and debt were the norm. During boom times, it was no big deal for an oligarch to borrow many multiples of his net worth. The borrowed capital would then be put to work in even more speculative ventures. Now all that leverage is killing them.

This is a deadly serious problem for Vladimir Putin (a man reputedly worth tens of billions himself) because it leaves his power base badly fractured. If the oligarchs go down the drain, Putin could too.

Russia as a country is in a little better shape, thanks to a huge currency surplus war chest. Russia has upwards of $530 billion in reserves by some estimates. That’s rainy day money that can be spent as needed to keep the people calm and Moscow on its feet.

But none of that will matter to Putin if his hidden power network, a large part of which depends on the oligarchs, is destroyed. If something isn’t done to stop the bleeding, Vlad could wake up to anarchy in the Kremlin... or a new challenger risen up from the ranks... or even a dollop of Polonium 210 in his borscht.

Too Much Credit, Amigo

Hugo Chavez, Venezuela’s fiery leftist President, has arrived in a similar place by a different route.

Chavez didn’t make the mistake of leveraging up or staking his power on a group of rich insiders. Rather, he made the mistake of giving away his most precious resource for free... forgoing hundreds of billions in revenues in an aggressive effort to buy friends.

As it turns out, Venezuela only has one big customer who pays full price for oil: the United States. Most everyone else gets it at a huge discount.

In 2005, Chavez formed something known as the “Petrocaribe” club. He might as well have called it the “Chavez will bribe you to be his friend” club, for reasons you’ll soon see.

The 18 Latin American countries in the Friends of Chavez club -- er, excuse me, Petrocaribe club -- suck down roughly half the oil Venezuela produces. (That’s 1.2 million barrels out of 2.4 million barrels per day total... a 25% decline since Chavez rose to power.)

The upshot is that Venezuela, a country whose output should be rising but is instead declining, gives away half its oil for next to nothing. Chavez charges Petrocaribe members 30 percent of the market price up front, on 90-day terms, with the balance paid in installments spread out over 25 years.

Thirty percent down, 90 days same as cash and a 25-year repayment plan. What a deal!

If that deal sounds like a steal, that’s because it is. Chavez fancies himself a great liberator... the hope and salvation of Latin America... and he will grease the palm of anyone who agrees with him and stands against The Evil United States. (Never mind that The Evil United States is Venezuela’s only big customer paying cash on the barrelhead.)Venezuela on the Precipice

Not only does Chavez give away half Venezuela’s oil to outsiders, he gives it away at home too. Thanks to mass subsidies, Venezuela has the cheapest gas prices in the world. You can fill up for your tank for twelve cents a gallon in Caracas... and that’s only the tip of the subsidy iceberg.

Not to put too fine a point on it, Chavez is a self-styled “revolutionary” with no concept of basic economics. He assumed the oil gusher would last forever, and spent money accordingly.

As if all the spending weren’t enough, Chavez has grossly neglected the maintenance and upkeep of PDVSA, the state-owned oil company. Rather than investing in technology and engineers, Chavez has ordered PDVSA to waste its time on hare-brained community schemes. He has installed political cronies in important positions, driven out key employees, and generally let the whole apparatus go to pot.

Now, like Putin, the falling price of crude is delivering the mother of all wake-up calls. Various sources estimate that if oil stays below $80 for long, Venezuela will have trouble paying its bills. Chavez is the type of guy who needs a frying pan to the face to see the error of his ways... and he is about to get it.

An Old Play From the Dictator’s Handbook

So what are Putin and Chavez going to do? Both men are in dire straits, and a ramp-up in oil production is not the answer.

Expanded oil output won’t help the oligarchs at this point. They need a higher price per barrel to shore up market values on their battered and bleeding holdings. And Chavez couldn’t expand production even if he wanted to. (Mazhar al-Sheridah, an oil expert with the University of Venezuela, says his country will need $32 billion and five years’ construction time to raise output.)

One option for both men is to lean hard on OPEC, and hope a round of deep cuts does the job of pushing oil higher. We’ll talk more about that in a minute. But there is another, older, more reliable play too... one that’s proven its effectiveness time and again in recent years.

Putin and Chavez can stir up turmoil on the cheap.

If there were such thing as a “dictator’s handbook” (or maybe a petrocrat’s handbook), you would find this play early on in the list of basic maneuvers. When things are going to hell at home, distract the populace (and the world) by starting a firestorm elsewhere.

It’s hard to solve a pressing problem with long-range tools like diplomacy and fiscal policy... but much easier to light a match and drop it in a drum of kerosene.

Return of the Fear Premium

For the past few years, crude oil traded with a hefty “fear premium” built in. The thought was that, with the supply and demand balance so tight, even the smallest conflict or disruption could have big ripple effects on the price and availability of oil.

Now that the markets are worried more about slowdown than runaway global growth, the fear premium in oil prices has gone away. If anything, it’s been replaced by a new deflationary mindset as “demand destruction” takes hold.

But “fear in the hearts of men” is back in the ascendant... in the hearts of Putin and Chavez anyway. As the walls crumble down around them, both could easily be on the verge of panic. Both know that oil prices must move higher if their regimes are to be saved from oblivion. And both are willing to do whatever it takes to save their own skins.

This is why falling oil is a geopolitical time bomb. Putin and Chavez could already be considered two of the most dangerous men on the planet. Now both men find themselves backed into a corner like wounded animals. And remember, the most dangerous animal of all is not the one hunting for its supper. It’s the one fighting for its life.

Whither OPEC?

We can’t know what’s taking place behind the scenes... what Putin and Chavez are saying to their closest advisers in their most urgent moments and so on. But we can know there’s a real powder keg brewing here. And OPEC is potentially a part of that mix too.

All I know is, if I were a ruthless petrocrat trying to save my regime from a downward spiral in crude oil prices, I would think big. I would try to set off the biggest, most explosive tinderbox possible, just to make sure my message gets through and the new “fear premium” takes full effect.

And if I could time that action with the actions of another powerful group, so much the better. That would just mean more bang for the geopolitical buck.

That’s where OPEC comes in...

In case you weren’t aware, OPEC is meeting later this week to discuss an emergency cutback in crude production. (Russia is not officially a part of OPEC, but Venezuela has long been a member.)

The market has been a tad jittery ahead of the OPEC meeting, but general expectations seem tame. Wall Street analysts are predicting a one million barrel per day production cut. There is also a general consensus that one million barrels won’t be enough to keep the price of oil from falling further.

Remember, too, that it isn’t just Russia and Venezuela who are hurting here. Many of the OPEC countries -- not least Iran -- have a lot riding on a high oil price. I suspect that OPEC will have to engage in a little “shock and awe” this week if they really want to get their message through. In 1973 they really took the gloves off, and we saw what happened the rest of that decade. Who’s to say they won’t do it again.

So there you have it. Mix geopolitical TNT with a paper currency fuse, and you’ve got a good chance of seeing energy prices spike higher before too long. Possibly much, much higher.

HUH? Doesn’t make sense. Chavez and Russia are at the mercy of US, and OUR ECONOMY, not vice versa. That’s becoming increasingly obvious. Chavez won’t last another two years with prices at this level, let alone lower.

I think the author is hinting at a really drastic cut in OPEC oil production although he doesn’t come right out and say so. There’s a silver lining in that dark cloud though. Maybe we’ll wake up and start the process of taking care of our own energy needs.

Yeah, think about what this is doing to "I'm-ona-jihad" in Iran. It has utterly destroyed his financing.

How ironic: Bush came into office with al-Qaeda in Afghanistan, Saddam in Iraq, Khaddafi in Libya, the nut in N. Korea, and Iran as the major threats to American security. He deliberately pretty much destroyed #1 and 2, forced #3 into surrendering his WMDs without a fight, and now has through sheer accident of fate neutralized to some degree Iran. Only NK remains.

interesting piece - thnx for posting

I knew gas was el cheapo in Venazuela, but didn’t know Chavez was practically giving away so much oil to Latin American countries. LOL, what a putz.

I absolutely agree, Iran is crossing its legs like a three year that has to pee just trying to hold off on annihilating Israel in the hopes they can get Obama in the Whitehouse.

Iran depends on high oil prices to fund its genocide war efforts, these falling oil prices may actually force Iran to take action ahead of time which is good, I would rather my enemy attacked out of the blue than to sit across the street building up more offensive powers on a daily basis.

It would be nice if Mr. Litle actually knew his history:

Venezuela is not the long term member of OPEC, they are the ORIGINAL OPEC nation. A Venezuelan, Juan Pablo Alfonso Perez, found OPEC with the Saudi’s and modeled it on the old Texas Railroad Commission (the TRC actually monitored and controlled Texas oil production back when the Houston price was the world price).

Read Adam Smith's great book ‘Paper Money’ to see how OPEC came into being.

In 1987, oil fell as low as $7 per barrel. Anyone who thinks that OPEC will get it's act together now is kidding themselves. The Saudi’s are going to use this market to teach their brethren a lesson about allowing price increases that encourage substitute energy approaches.

The Iraqi's are going to increase production.

Don't be surprised if the US announces it will REDUCE its purchases of Venezuelan crude. Venezuelan crude is best suited for our refineries, it will not be easy for them to sell elsewhere.

“Putin and Chavez can stir up turmoil on the cheap.”

Maybe Joe Biden is right on Obama being tested in his first six months like JFK. Russian missles in Venezula?

I don't think the underlying threat is OPEC reducing output.

Remember the cornered animal example in this article.

The real threat is that one only knows that a cornered animal will fight. How he will fight depends on his mental capabilities.

I would more likely expect Russia to do something to upset middle eastern oil production to the point that Russian oil became more valuable.

Say for instance egg Iran into war with Israel, this dragging the entire middle east into the conflagration.

Or doing something to bait Israel into the first strike...who knows?

All we do know is that dictators have used war for centuries to build their power base at home.

Many threads I have said this, but the power is in the hands of those who purchase, not sell the commodity, whether it is Oil or manufactured products from China.

Once purchasers stop purchasing, the sellers will suffer big-time.

Even if OPEC cuts production, I don’t know how this will really put a floor under crude prices.

During the entire runnup of prices over the past few years, the big ‘supply/demand’ explaination was Excess Global Production Capacity. In fact, this excess got down to ~1MM bbls/day at one point. If OPEC now cuts production, it does not reduce Excess Global Production Capacity. In fact as demand continues to drop and new production comes online, this number will continue to increase.

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