Why Oil Prices are Falling: The Secret Deal Between the U.S. and Saudi Arabia14 min read

Why Oil Prices are Falling: The Secret Deal Between the U.S. and Saudi Arabia

Dear Readers,  

It’s been a while since I wrote specifically about the market.

So this week, I want to touch briefly on the markets before I get into the real reason why oil prices are falling; and no, oil hasn’t fallen just because of a supply glut.

In many of my past letters, I said that we should be very careful how we invest this year; that while the market could continue its meteoric rise, the later half of the year may bring us extreme volatility:

“Despite the uncertainties around the world, the stock market continues to march on (as I mentioned they would likely do in my Letter, ” What to Expect for 2014“).

Last year, and every year post-2008, I was confident the stock market would continue to set new highs.

This year, I am much more cautious.

It’s been over five years since the great crash of 2008. The markets have climbed, creating newfound wealth for the 0.001 per cent. Yet, as I sit here writing this, I can’t help but feel worried for our future.”

Since the end of summer, the market has dropped and rebounded in volatile fashion.

As a result, the VIX index, a measure of how volatile the S&P 500 is likely to be over the next 30 days, has shown some very unusual and unprecedented activity.

And I am not talking about the VIX’s obvious spike since the beginning of October.

Over three consecutive trading days starting from October 17 to October 21st, the VIX has dropped more than 10%. The VIX has NEVER dropped more than 10% for 3 days in a row…ever.

This has no doubt fed into concerns that the market may either be about to experience more turmoil, or there is a much bigger force at work stabilizing fear in the market.

Thoughts of my past letters, such as, “How Does the Fed Influence the Stock Market,” come to mind…

Traders (or market manipulators) have now poured over $757 million this month into the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), an ETF opposite of the VIX that appreciates when markets are calm.

This is the largest amount for any month since the ETF began trading in 2011.

With elections around the corner, and the Fed meeting next week, don’t be surprised if you see the market hold steady, and then head for higher short term ground.

While the upcoming Fed meeting is not supposed to deliver new forecasts or a press conference from Fed Chair Janet Yellen, the central bank is expected to wrap up its historic bond-buying program.

Most of this has already been priced into the market, but it seems people are looking for a change in wording from the Fed committee regarding interest rates and the extension of keeping bonds on the Fed’s balance sheet.

When the Fed holds onto bonds, it helps keep prices up and yields lower by limiting the supply of securities trading on the public markets. This provides stimulus to the economy just as a cut in the Fed’s benchmark interest rate would.

As I mentioned in many of my past letters including, “The Biggest Buyer of Garbage,” the Fed has been the biggest buyer in the Treasury market, or simply put, United States’ debt.

The Fed has become the largest holder of U.S. government securities.

What does that mean?

It means the world’s most powerful country is now the most heavily indebted to the world’s most powerful bank.

It means the Fed now completely controls the fate of the United States*.

(*While the Fed has always sunk its teeth deeply into the U.S. over the last century, the onset of QE has now sealed America’s fate.)

Janet Yellen has already talked about keeping a multi-trillion-dollar portfolio for years, saying a decision on when to stop reinvesting maturing bonds depends on financial conditions and the economic outlook.

Last month, Yellen said that it “could take to the end of the decade,” to shrink the balance sheet back to normal historical levels. In other words, it doesn’t seem she is forecasting any sort of extreme growth.

With new bond purchases coming to an end, and interest rates already at historical lows, what’s the next strategy in helping the U.S. economy continue its path of growth?

Why Oil Prices Are Really Falling

At the end of June, crude oil futures traded above $105. Since then, it has dropped over 22% to the current price of just over $81.

Lower energy costs means stronger growth for the American economy. It paves the way for cheaper commodities prices, but more importantly, it paves the way for higher consumer spending.

Via Bloomberg:

“A report by Andrew Kenningham, senior global economist at Capital Economics, attempts to gauge the difficult-to-measure global lift from lower oil prices. “A $10 fall in the price of oil transfers the equivalent of 0.5 percent of world GDP from oil producers to oil consumers,” he writes. That in turn will have a knock-on effect on global consumption, because consumers tend to spend more of their income than businesses.

Assuming consumers spend half their savings from cheaper oil, Kenningham continues, “a $10 fall in the oil price would boost global demand [for goods and services] by 0.2 to 0.3 percent.”

In order for the U.S. economy to continue with the Fed’s goal of 2% inflation moving forward, Americans need to start spending more money.

The strategy of low interest rates to stimulate the housing market and consumer spending has exhausted.

With QE coming to an end, what’s left to stimulate the American economy?

As the holiday season nears next month, oil prices continue to fall, with global oil prices posting a fifth consecutive weekly loss.

Is it simply a coincidence that oil’s decline has come on the heels of the end of QE?

Is it possible for the United States to manipulate the price of oil to further stimulate growth?

Let’s take a look.

The Secret Deal with Saudi Arabia

On September 11, Saudi Arabia inked a deal with the U.S. to drop bombs on Syria.
But why?

Saudi Arabia possesses 18 per cent of the world’s proven petroleum reserves and ranks as the largest exporter of petroleum.

Syria is home to a pipeline route that can bring gas from the great Qatar natural gas fields into Europe, making billions of dollars for Saudi Arabia as the gas moves through while removing Russia’s energy stronghold on Europe:

From my Letter, The Real Reason for War in Syria:

“Syria’s location puts it smack in the middle of Qatar and Turkey; a perfect crossroads for a natural gas pipeline that could make Qatar, the world’s largest exporter of liquid natural gas (LNG), a strong supplier of gas to Europe.

A gas pipeline from Qatar to Turkey means Russia will lose its dominance and control over energy supplied to Europe; thus losing lots of money and power.

However, Syria’s leader, Bashar al-Assad is in deep with Russia and thus, provides a major roadblock for Saudi Arabia.

“Russia has been helping Syria by supplying arms, fighter jets, tank parts, advanced anti-ship cruise missiles, long-range air defense missiles, military officers as advisers, diplomatic cover, and a boat load of cash, since the Syrian conflict began more than 2 years ago.

It’s no wonder why Assad said no to the second route; he’s obligated to help block the flow of natural gas out of the Persian Gulf into Europe to ensure that Russia remains in control of European energy.”

Now I want you to focus on what I continued to write in that Letter from September 8, 2013:

“…If Assad is forced out, Qatar could put in place a puppet regime in Syria that will allow them to build a pipeline into Europe and give Qatar the ability to sell natural gas to Europe, undermining Russia.

Of course, the Saudis have also been helping the rebels because it too wants to control the flow of energy from the Persian Gulf to Europe.

There are even rumours that Saudi Arabia and Qatar may be ‘bribing’ US congressmen to approve war on Syria in order to dethrone Assad.

Via Press TV:

“American historian Webster Griffin Tarpley says that Saudi Arabia and Qatar are offering bribes to the US congressmen for a military strike against Syria.

“The Saudis and the Qataris are reported to be deploying huge amounts of money for bribery, bribery to the families and political and business interests of these members of congress,” Tarpley said in an interview with Press TV on Friday.

“Hillary Clinton has received 500,000 dollars in jewelry from the king of Saudi Arabia and Hillary Clinton just came out for war,” he added.”

Over the last year, Qatar and Saudi Arabia have been urging for U.S. support to unleash airstrikes on Syria.

This year, with the coincidental movement of ISIL into Syria, the U.S. now needs the support of Saudi Arabia to attack the extremist group Islamic State.

Thus, ironically on September 11, the United States made a trip over to Saudi Arabia to ink a deal that would pave the way for air strike bombings in Syria.

Via WSJ:

“The Americans knew a lot was riding on a Sept. 11 meeting with the king of Saudi Arabia at his summer palace on the Red Sea.

A year earlier, King Abdullah had fumed when President Barack Obama called off strikes against the regime of Syria’s Bashar al-Assad.

This time, the U.S. needed the king’s commitment to support a different Syrian mission-against the extremist group Islamic State-knowing there was little hope of assembling an Arab front without it.

At the palace, Secretary of State John Kerry requested assistance up to and including air strikes, according to U.S. and Gulf officials. “We will provide any support you need,” the king said.”

Of course, it would be stupid to think that the U.S. would spend nearly $1 billion dropping bombs on Syria and Iraq without some sort of mutual benefit.

It’s no wonder U.S. support of Saudi Arabia comes with certain terms.

Again, via WSJ:

“…The process gave the Saudis leverage to extract a fresh U.S. commitment to beef up training for rebels fighting Mr. Assad, whose demise the Saudis still see as a top priority.

…Wary of a repeat of Mr. Obama’s earlier reversal, the Saudis and United Arab Emirates decided on a strategy aimed at making it harder for Mr. Obama to change course. “Whatever they ask for, you say ‘yes,'” an adviser to the Gulf bloc said of its strategy. “The goal was not to give them any reason to slow down or back out.”

Arab participation in the strikes is of more symbolic than military value. The Americans have taken the lead and have dropped far more bombs than their Arab counterparts. But the show of support from a major Sunni state for a campaign against a Sunni militant group, U.S. officials said, made Mr. Obama comfortable with authorizing a campaign he had previously resisted.

… For the Saudis, Syria had become a critical frontline in the battle for regional influence with Iran*, an Assad ally. As Mr. Assad stepped up his domestic crackdown, the king decided to do whatever was needed to bring the Syrian leader down, Arab diplomats say.

In the last week of August, a U.S. military and State Department delegation flew to Riyadh to lay the ground for a military program to train the moderate Syrian opposition to fight both the Assad regime and Islamic State-something the Saudis have long requested.”

*Iran shares the South Pars / North Dome field with Qatar – the world’s largest gas field. Please see  The Real Reason for War in Syria for more.

In other words, the Saudi-U.S. alliance comes with very specific terms aimed at dethroning Assad, positioning against Iran, and in the end, removing Russia as an energy powerhouse in Europe.

You may be thinking:

“What exactly does Saudi Arabia bring to the table?”

“What is it that Obama might ask for?”

“If Syria is overthrown, it would already strike a major blow to Russia. What else could the U.S. want?”

Removing Assad and building a pipeline from Qatar to Europe is the ultimate goal, but it will take many years.

With Russia’s current global momentum, the U.S. needs to strike Russia now.

But how?

Russia’s Energy Dependance

Oil has been the primary reason for Russia’s success, fueling an economic boom that grew 7 percent on average from 2000 to 2008.

While globally Russia appears strong, its Achilles’ heel is the price of energy.

Russia needs high oil prices to support its economy. As of 2012, the oil and gas sector accounted for 16% of Russian GDP, 52% of federal budget revenues and over 70% of total exports.

Russia’s latest budget requires oil prices to average at least $100 a barrel in order to cover the government’s spending promises. This budget will fall into deficit next year if oil is less than $104 a barrel, according to investment bank Sberbank CIB.

At $90, Russia will have a shortfall of 1.2 percent of gross domestic product.

According to Maxim Oreshkin, head of strategic planning at the Finance Ministry, the Russian budget loses about 80 billion rubles ($2 billion) for every dollar the oil price falls.

According to Charlie Robertson, the chief economist at Renaissance Capital Ltd., Russia’s economy could contract 1.7 percent in 2015 if crude averages $80 a barrel.

The current price of oil is $81.

If you recall back to the 80’s, the Soviet Union collapsed due to low oil prices.

Via Bloomberg:

“An oil glut in the 1980s led to a six-year decline in prices, contributing to the Soviet Union‘s failure to keep its shelves stocked with basic consumer goods and undermining its economy. Putin has described the collapse of the Soviet Union as the greatest geopolitical catastrophe of the 20th century.

Crude prices remained low throughout Yeltsin’s presidency, when the economy was racked by hyperinflation, wage arrears and falling standards of living that culminated in the 1998 Russian financial crisis.

The “addiction” to oil “is a big part of why the Soviet Union collapsed,” said Michael Bradshaw, professor of global energy at the Warwick Business School in Coventry. “Putin rode a wave of high oil prices in his first two terms, so his job now could get trickier if prices stay down.”

With the current pain being felt by recent sanctions, Russia’s growth is now practically zero.

The nation will also have to find new investors*, tap its sovereign wealth funds to bail out companies blocked by sanctions from international borrowing, or print money (and further devalue the Ruble), in order to sustain its budget.

(*Could this be China’s bargaining chip with Russia on gas prices? See my Letter, “China and Russia Strike Massive Blow to America“).

Russia will also have to entrench on all fronts.

If you want to strike an immediate blow to Russia, aim for its Achilles’ heel: Energy.

And that is exactly where the U.S. is firing its arrows.

Back to Saudi Arabia

As I mentioned, Saudi Arabia ranks as the largest exporter of petroleum and also the largest holder of spare capacity.

While the Organization of the Petroleum Exporting Countries (OPEC) is generally the technical arbiter of the price of oil, nations within OPEC – such as Saudi Arabia – don’t have to follow the pricing guidelines.

In other words, if Saudi Arabia wanted to slash its selling price of oil, it could. And that is exactly what has happened.

On October 1, 2014, shortly after the U.S. dropped bombs on Syria on September 26 as part of the September 11 agreement,  Saudi Arabia announced it would be slashing prices to Asian nations in order to “compete” for crude market share.

It also slashed prices to Europe and the United States.

Via Anadolu Agency:

“Saudi Arabia plans to sell oil cheap for political reasons, one analyst says.

To pressure Iran to limit its nuclear program, and to change Russia’s position on Syria, Riyadh will sell oil below the average spot price at $50 to $60 per barrel in the Asian markets and North America, says Rashid Abanmy, President of the Riyadh-based Saudi Arabia Oil Policies and Strategic Expectations Center

The marked decrease in the price of oil in the last three months, to $92 from $115 per barrel, was caused by Saudi Arabia, according to Abanmy.

With oil demand declining, the ostensible reason for the price drop is to attract new clients, Abanmy said, but the real reason is political.

Saudi Arabia wants to get Iran to limit its nuclear energy expansion, and to make Russia change its position of support for the Assad Regime in Syria. Both countries depend heavily on petroleum exports for revenue, and a lower oil price means less money coming in, Abanmy pointed out. The Gulf States will be less affected by the price drop, he added.”

Could the U.S. have persuaded Saudi Arabia during their September 11 meeting to lower its own price of oil in order to hurt Russia, while stimulating its own economy?

That’s exactly what the vice-president of Russia’s state-owned oil behemoth Rosneft thinks:

Via RiaNovosti:

“Prices can be manipulative. First of all, Saudi Arabia has begun making big discounts on oil. This is political manipulation, and Saudi Arabia is being manipulated, which could end badly.

The second factor is the stolen ISIL [Islamic State] oil, which reaches the market through Turkey and Israel with a triple discount. It is not much, but it is stolen, so it is cheap,” the Rosneft vice president said.” – Mikhail Leontyev

Interestingly, Saudi officials have privately admitted to oil market participants that it will accept oil prices below $90 per barrel, and perhaps down to $80, for as much as the next two years.

Coincidently, that is not only where the price of oil is now, but also the price where it would have a significant impact on the Russian economy, as I just mentioned earlier.

While Saudi Arabia has slashed oil prices, China – somewhat in support of Russia – has turned its back on Saudi Oil and instead has chosen to deal with Columbia and Russia only – for now:

Via Houston Chronicle:

“The global oil market is undergoing dramatic and unexpected changes well beyond our borders, and frankly, our control.

The latest surprise comes from China, which chose to ignore the lower Asian prices on offer from Saudi Arabia and instead boosted imports from Colombia, Bloomberg reports. China also boosted imports from Russia, as the world is awash with crude, largely because the U.S. is now producing so much of its own.”

Clearly, China is giving face to Russia in this matter and likely going to ask for the same face back as it continues to negotiate the price of their massive gas deal struck earlier this year.

What Next?

Given the size of the oil market, Saudi Arabia and the U.S. can only do so much to keep the price of oil down.

And while the U.S. has been planning a long time to prepare for this lower oil price scenario by increasing production at home, OPEC members may eventually say enough is enough.

Again, via Andolu Agency:

“Caspian Strategy Institute analyst Mubariz Hasanov told Anadolu Agency (AA), that a single country cannot have much effect on oil prices.

“The U.S. and Saudi Arabia alone do not have the power to seriously affect oil prices”, Hasanov insisted. “No country has this kind of power, unless it starts a war or executes a strong embargo, as was done in 1973.”

“Unless it starts a war…”

Is that not what’s happening in the Middle East?

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Until next time,
Ivan Lo
The Equedia Letter
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