As we search for threats to Wall Street, the oil market pushes its way onto our screen. A month ago, a Louisiana wildcatter who has been a client of Polyconomics for several years called to tell me how desperate the situation was in the oil fields, with a barrel that sold for $18 as 1997 opened selling for $8 and change. Another independent oilman called Tuesday to tell of Texas crude going for $5/bbl and places in the Rockies where it has been dumped for $4 and change. The carnage to producers is horrific, with oilmen who have been in the business for half a century losing everything they have as they must close down wells yielding oil at a cost above $10/bbl. The thousands of stripper wells that produce enough oil when a barrel fetches $12-15/bbl -- as little as 25 barrels a day -- to keep small farms and ranches solvent, are closing throughout the oil patch, most never to be reopened because of the prohibitive start-up costs.
Monetary deflation is the real culprit, the hammer that began the process of driving down the oil price to levels, when adjusted for inflation, not seen since the darkest days of the Depression. Obviously, there is more going on with oil than the direct result of the Fed’s dollar deflation. The IMF influence in worsening the world economy bears some responsibility. The crusher, though, is Iraqi oil, which is pouring into the world market at the rate of 1.8 million bbl/day via the United Nations oil-for-food program. This is out of global consumption of 75 million bbl/day. The conventional wisdom is that if the embargo on Iraq were lifted, its oil would come out at an even faster rate, further driving down the price. Exactly the opposite would happen. A lifting of the sanctions would restore Baghdad’s incentive to optimize the oil price with its fellow producers. Following the law of unintended consequences, the UN program offers Iraq no incentive to manage its oil reserves within the framework of the oil-producing states. This is because it permits Baghdad to export a dollar amount, $5 billion every six months, not a volume amount. The U.N. takes a significant cut, as much as 40%, to pay the costs of its various Iraqi enforcement and humanitarian programs -- which is why the UN has an incentive to have Iraq export as much as it takes to get to $5 billion. In 1997, with higher prices, Iraq exported 900,000 bbl/day. In 1998, with prices halved, it sold 1.8 million bbl/day. In other words, the doubling of Iraq’s volume of oil exports exceeds the surplus from all sources flowing into the world economy.
The other oddity is that the UN permits Iraq to spend $300 million a year upgrading its oilfield infrastructure so that it could produce enough oil to add up to $5 billion every six months. Iraq is second in the world in proven oil reserves, but the 1991 Gulf War destroyed a good bit of the infrastructure. Now because of the collapse of oil prices, the only investment in oil production on the planet is in Iraq. The implications are ironic and profound. As the U.S. and world economies roll along on dirt-cheap energy, gobbling 75 million bbl/day and climbing, the margin of usable reserves is dwindling even as inventories appear to climb with the surplus. What kind of cushion is out there? The International Energy Agency, a Paris-based consumer organization founded in 1974, has projected the inventory build at 3 million bbl/day, but the Independent Petroleum Association of America can only identify between 600,000 and 700,000 bbl/day. The IEA is the authoritative source, but the market is aware of the IPAA discrepancy. All it would take for the market to bid oil up sharply would be for the IEA to concede it is in error, with its consumer bias.
Even if it doesn’t, the reality of supply and demand is a brick wall that will be met in the not-too-distant future. When it does, the oil price could easily climb well above the price implied by gold at $286, the swing being the result of real forces correcting for the steep decline, not monetary error. This would add to the energy costs of consuming countries and their people and industries around the world, adding to the weakness developing at the base of the U.S. economy. We should expect this to decrease the demand for dollar liquidity, which is what happens when commerce declines. Because the Federal Reserve is not following a commodity target, but is targeting the real economy, it would be lowering interest rates into the teeth of the decline of the demand for liquidity. In this troublesome scenario, we could expect an increase in the gold price and an acceleration in the increase in the price of oil as markets race to acquire inventories before the price hikes. I wouldn’t be surprised to see the Netherlands central bank, which was smart enough to unload gold at the beginning of the deflation, adding to its gold reserves as the process reverses.
What worries some of our oil people is not only the increased U.S. dependence on Middle East oil, but the increased leverage of Iraq in managing the marginal barrel of oil. If there is less available capacity than is implied by the IEA projections, only Saudi Arabia could quickly -- in a year -- add 2 million bbl/day to world production. Increased inventory demand could blow right past that number. What to do about all this? Fed Chairman Alan Greenspan, who has been several steps behind the curve throughout the process, should be thinking ahead. The Fed could manage some of the adjustment by switching to a commodity target instead of its rear-view mirror economy target. As far as Iraq is concerned, our political Establishment should swallow the failure of our Iraqi policy and lift the embargo in exchange for a Baghdad agreement to permit UN monitoring for weapons of mass destruction. Bluster and bombs continue to strengthen Saddam Hussein in a way that decreases not only the stability of the Middle East, but also the risks to the world economy.
SENATE TRIAL: There was stunned silence on the Jim Lehrer "NewsHour" last night when John Danforth, the former U.S. Senator from Missouri, highly respected as a Republican moderate during his years in Washington, concluded the otherwise happy-talk with three other former Senators. After Danforth agreed with former Sens. Bennett Johnston [D-LA], Dale Bumpers [D-AR], and Warren Rudman [R-NH] that the trial should be expedited, he firmly asserted that if he were still in the Senate he would have to vote for the President’s removal from office. If he is not removed, said Danforth, he will have lowered the standards of presidential behavior so far as to be totally unacceptable. To hear that coming from a pit bull in the House or Senate is one thing. To hear it from Danforth is quite another. The other three former Senators had just dumped on the House and recommended a trial without direct votes on conviction or acquittal -- because everyone knows Clinton will be acquitted. Danforth’s comment could only be taken as a slap in their faces for their willingness to tolerate a dramatic lowering of standards. This is the kind of debate the Democratic strategists want to avoid. They have to be worried that in the course of a trial that would include witnesses driving home the seriousness of the two articles of impeachment, partisan Democrats and mushy Republicans like Rudman would be ashamed of voting for acquittal and the President would be convicted and expelled. The President’s only chance is a successful defense on the facts, which even the NYTimes gags on. Democrats must be able to convert the process to a censure vote or they suspect Clinton is toast. House Speaker Denny Hastert could put a stop to that simply by announcing that the House has concluded its work on the matter, and if the Senate passes a censure resolution at any time, it would not be taken up by the House. The odds against conviction are shortening every day, although I personally leave open the slight possibility that the President’s defense will be at least technically persuasive.