By Chris Cook & Mahmood Khaghani

The Shape of Things to Come

April 28, 2020 - 15:17

Like everyone else, Iranians observed the extraordinary U.S. oil market events of 20th & 21st April 2020 and wondered what on earth was going on, and what it means for Iran's future as a major oil producer.  In Tehran, in October 2008 I recall similar astonishment as the global dollar financial system experienced a meltdown from which Iran was safely insulated. 

It has been said that history does not repeat itself, but it does rhyme. Once again, Iran is insulated from market turmoil through US financial and physical oil market sanctions and is 'on the outside looking in'. Global lockdowns are believed to have cut oil product demand by up to 30m barrels per day and this demand shock is propagating up the supply chain of refineries and oil distribution systems to producers at the well. 

Market shocks
Coronavirus has shocked the physical oil market into cardiac arrest. Fragmented and viciously competitive producer members of oil institutions such as OPEC and “OPEC+” have no viable response. The media stories everywhere of a Saudi/Russia “Price War” reminded me of two bald men fighting over a comb, because there is no physical demand other than for strategic reserves even for cheap oil until product oversupply is cleared and shut down refineries re-open.

Of course, this is not the first oil market cardiac arrest. In 2008, oil prices went into free-fall from a clearly manipulated 'spike' to $147/bbl in July 2008 all the way to $35/bbl in December and nothing OPEC did could arrest the fall. The reason was that the 2008 shock was not due to any lack of physical demand to refine oil, but rather to the inability of buyers to finance global oil deliveries as the dollar trade finance banking system froze as banks lost trust in each other.  In order to understand the current market cardiac arrest and how to revive the patient, I shall outline my perspective of US physical and financial energy strategy since 2008. 

Obama: Transition through Gas

The organising principle of US foreign policy has for 100 years been US energy security and independence and President Obama's smart Transition through Gas energy strategy reflected this. The aim of Transition through Gas was to reduce US reliance on Saudi oil by increasing US oil production and to swing domestic and global energy investment to gas & renewable energy production and energy efficiency ('Fifth Fuel'). 

The story of a so-called oil war between Saudi Arabia and Russia aimed at killing off US shale oil production is a myth: the true struggle for market share appears to be an attempt by a US/Saudi Arabia partnership to out-compete Russian oil sales to Europe and elsewhere.Obama was a Wall Street president who took an unconventional approach to funding such colossal energy investment.  His strategy followed that of Henry Kissinger who convinced the Shah of Iran to agree to a 400% increase in oil prices after the 1973 'Oil Shock' which had the effect of making development of Alaska, US Gulf, and North Sea oil economic. So immediately Obama took office in 2009 he acted to re-inflate, support and hold oil prices above $80/barrel for four years while capping politically sensitive US gasoline prices to avoid putting at risk his 2012 re-election. 

This four-year oil boom with prices between $80 & $120/barrel brought a wave of petrodollars from producers flooding into US Federal Reserve Bank (“Fed”) accounts, particularly from Saudi Arabia under an energy security agreement with U.S. made in 1945. To avoid exchange rate problems, the Fed created new petrodollars and swapped them for US Treasury Bills in a neutral asset swap operation termed Quantitative Easing (“QE”). However, the economic myth propagated by the Fed and sustained by uncritical global media was that this neutral financial asset swap could in some magical way act as a “stimulus” for the US economy when the true reason was to quietly accommodate oil producer Petrodollars. 

In order for oil producers to support high oil prices, they must be able to fund stocks of excess oil held off the market and be able to access bank finance for the flow of oil payments. In order to achieve this, Wall Street used new investment instruments: firstly 'passive' oil funds investing in oil market futures contracts, and secondly, secret Enron-style oil prepay funding.  

In this way, Wall Street and North Sea oil producers were able to support the global benchmark price set by ICE Brent/BFOE crude oil contracts, and Saudi Arabia's BWAVE pricing formula based on it. From 2001 to date the North Sea oil market tail has wagged the global oil market dog.

So the vast inflows of petrodollars during President Obama's first term in office enabled US banks to fund shale oil & gas and renewable energy projects, while historically high US fuel prices encouraged energy-efficient vehicles. By 2014 the US had transitioned from natural gas deficit to surplus; US shale oil production had increased by some 5m bpd, while fuel consumption had fallen by 2m bpd. Similar trends elsewhere of increasing supply and falling consumption saw structural global oil deficit quietly transform into a surplus.

In late 2011 in Tehran, with oil prices well over $100/bbl, I forecast to general disbelief that when the Fed ended QE, the oil price would collapse to $45/$50 bbl. This is exactly what happened when the US finally turned off the QE dollar hosepipe in 2014 while opening a massive military base in gas-rich Qatar. The US also commenced overtures to Iran bearing in mind both the greatest global gas reserves and immense development opportunities for low-cost oil long coveted by US oil majors.

In late 2014, Saudi Arabia awoke from a petrodollar coma to see their power over the US vanish along with their energy security. As a result, Saudi Arabia redirected oil proceeds to the Euro, where a main aim of European Central Bank policy since inception has been to back Euro currency with no intrinsic value with lending based on objective utility of oil and gas energy. So as with Fed dollar QE, the true reason for Euro QE in March 2015 was not stimulus but was simply to accommodate purchases of € securities. 

However, the unexpected election in November 2016 of President Trump changed everything.

Trump and energy dominance

Perhaps the most important of President Trump's motivations, due to an intense personal animosity, is to erase Obama's political legacy and in particular his energy strategy.  But it was a surprise to many observers that Gary Cohn (ex-Goldman Sachs and a Democrat) as Director of the US Economic Council and Rex Tillerson (ex-Exxon CEO) as US Secretary of State were willing and able to serve the Trump administration

Cohn architected and co-founded in 2001 what became the globally dominant Intercontinental Exchange (ICE) through which Wall Street came to dominate and financialise oil markets, while Tillerson was the most powerful US oil executive by far. Together they devised and implemented the US Energy Dominance strategy which was announced by President Trump on 29th June 2017.

As the name suggests, President Trump's 'America First' doctrine when applied to oil and gas markets aimed to massively increase US production in order to dominate global markets with what officials have termed “Molecules of US Freedom” and so take back control of global oil market pricing via oil & gas exports.

So on 1st July 2017 after 16 years of pricing oil using the ICE BWAVE formula, Saudi Arabia switched to prices generated by the Platts reporting service for cargoes of Brent/BFOE oil. For six months huge passive fund investment poured into global oil futures contracts, thereby re-inflating the price. Three months later at the end of March 2018 and nine months to the day after the strategy commenced, Cohn and Tillerson simultaneously left the Trump administration, leaving the strategy to be rolled out over the next two years.

So for the next 18 months, the Fed steadily reduced its balance sheet by selling Treasury Bills to release dollars. Within six months in September 2018, the ECB ended Euro QE, and Fed Treasury Bill sales continued until September 2019. 

U.S. and the oil standard

Whoever was responsible for the Abqaiq attack on Saturday, 14th September 2019, the resulting spike in oil and product prices required massive amounts of dollar funding to cover losses on derivative contracts. So Monday 16th September saw an unprecedented 'spike' in the sale and repurchase (“Repo”) of US Treasury Bills through which the Fed supplies dollar liquidity to four major US clearing banks. However, this massive Repo spike was only the beginning: from then on, the programme of exchanging dollars for short term Treasury Bills involving only these four banks which became known as 'NotQE' continued at a rapid rate.

Iran now has no options other than to pursue improbable and unorthodox market solutions in order to resolve an impossible economic situation, by a two-stage process of resolution and transition.
But the shape of the Transition to come is another story.
Meanwhile, through the second half of 2019, oil prices were otherwise stable in a range between $55 and $60/barrel. The more the price exceeded $60/bbl the more shale producers sold oil forward, which enabled them to borrow from banks to finance drilling. When prices fell below $55/barrel, financial buyers appeared.
As a result, the US petrodollar funding system has quietly been completely reconfigured, as Saudi PetroEuros returned to U.S. to be swapped for short term Treasury Bill petrodollar holdings. Where petrodollars indirectly funded shale oil producers through bank lending, shale oil production will now be funded via the same three-way prepay mechanism used by Enron for a decade to secretly defraud their investors and creditors. The difference now is that where Enron's third-party funders were two of the Big Four private banks, now it is the Fed itself which is the third party funder.

Meanwhile, the waves of debt advanced to the US shale oil industry are beginning to come due and the Big Four banks are all preparing to foreclose on these debts and take ownership of shale oil assets. These banks plan to use production sharing LLC 'capital partnerships' with operating partners while oil majors such as Exxon appear also to be aiming to consolidate distressed shale oil assets using similar funding.

So to cut a long story short, the planned outcome of the US Energy Dominance financial energy strategy, was to support and loosely peg oil prices by controlling the benchmark price around $55 to $60/barrel.  By pegging the dollar to an “Oil Standard” in this way prepay funding of US oil reserves has essentially monetised US oil 

Enter the dragon

Producers have controlled the oil market for so long they believe this to be their God-given right, forgetting that buyers are also capable of asserting market power. For years China's energy strategy has been to build and fill enormous oil storage capacity, now in excess of 1.2 billion barrels, while a fleet of new and efficient oil refineries has been built with capacity well in excess of China's product needs, and aimed at exports. 

As Iran is painfully aware, China's ability to ignore US sanctions means that they have become oil buyer of last resort at distressed prices, and may, therefore, dump cheap oil products into the market with which other refiners cannot compete. China has also discussed cooperation with other major oil buyers, particularly India. Other countries in oil deficit, notably EU nations, also have an incentive to join a cooperative 'buyer's club'.

So in my view, China has been preparing for years to assert 'buy-side' consumer oil market pricing power and the unprecedented demand shock propagating from China has created the perfect opportunity. When the oil market recovers from this cardiac arrest which broke the US/Saudi oil peg I believe that China can and will assert buy-side market power, probably in loose cooperation with other major consumers who see no reason to continue to transfer up to an additional $30/barrel to producers.

Oil wars

The story of a so-called oil war between Saudi Arabia and Russia aimed at killing off US shale oil production is a myth: the true struggle for market share appears to be an attempt by a US/Saudi Arabia partnership to out-compete Russian oil sales to Europe and elsewhere. Whatever the geopolitical truth of it, the collapse of product demand far in excess of any feasible voluntary oil production cuts makes talk of market share redundant, when there simply is no market to share.

So once enough refineries shut down to allow surplus oil on the market to begin to clear and a physical market price to re-emerge we will see two struggles begin. Firstly the struggle between buyers and sellers, and when, as I expect, the buyers win, the continuing struggle for oil market share between producers.

In my view, the crazy spike in prices of the US WTI oil futures benchmark price to a negative price of $37/bbl represents a historic point of failure from which the contract will not recover. It seems to me there is now an urgent need for a temporary resolution of the broken oil and products markets while a transition to new and sustainable global energy and financial markets get underway.

On the outside looking in
 
As the great author, Arthur Conan Doyle wrote: “Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth” 

Iran now has no options other than to pursue improbable and unorthodox market solutions in order to resolve an impossible economic situation, by a two-stage process of resolution and transition. The resolution step is to re-purpose existing structures and infrastructure with no change in the law. This then provides the basis for proof of concept of smart market and energy fintech innovations which enable transition to sustainable low carbon and low cost physical and financial solutions.

Resolution

My colleagues and I have long promoted 21st C Iranian physical and financial markets in oil products, but these have always been resisted by vested interests.  However, global collapse of product prices has now seen Iranian product prices converge with neighbouring countries, thereby neutralising certain vested interests. Our proposal for an interim resolution of Iran's economy builds upon existing subsidy and rationing policy and technology for oil products.

Firstly, our innovation is to simply for the government to issue an “Energy Dividend” of vouchers or credits, to Iran's population, each of which will be accepted in payment for products.

Because the Euro 5 standard for gasoline is used throughout Eurasia, we propose that each “Energy Credit Obligation” (ECO) will be returnable in payment for 1 litre of Euro 5 gasoline. Such standard ECOs will also be accepted by refiners and distributors, in payment for other fuels at a discount or premium to Euro 5 gasoline.

Refineries who issue such ECOs would no longer buy crude oil in exchange for conventional currency such as riyals or dollars since to do so exposes them to the risk of oil price fluctuations. Instead, refiners will enter into production sharing partnership agreements or oil/product swaps with oil suppliers in exchange for a percentage entitlement to the flow of ECOs.

So the ECO represents prepayment backed by the Iranian government and energy complex for the eternal intrinsic use value of energy, and in uncertain times many investors seek such assets. In order to build trust in the ECO, issuance must be transparent to everyone, and I addition must be overseen by professional service providers with a stake in the outcome who manage issuance and redemption of ECOs against use.

Transition

The ECO represents a fixed point upon which 21st C smart energy markets and economy may be introduced by Iran's greatest resource – one of the greatest global pools of intellectual capacity - to collaborate in solving humanity's greatest challenges.

Chris Cook is former director of the International Petroleum Exchange where his innovations included legal design of the UK Natural Gas futures contract. His focus at ISRS – University College London is to create 21st C networked markets in services through Financial Technology based on mutual agreements between people, not machines.


Mahmood Khaghani, former director-general of the Caspian Sea and Central Asia Department at Iran’s Ministry of Petroleum. He is now an advisor to IRIEMP- University of Tehran & Education and Research Institute -ICCIMA



 

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