The Dangerous Game Between Iran and the U.S
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The current state of high alert in the oil markets is entering its third year as tensions between the U.S., Israel and Iran over Iran’s uranium enrichment program have risen. Details of military maneuvers and instances of financial warfare have placed a bid underneath the price of Brent crude (NYSEMKT: BNO), the benchmark for oil pricing in most of the world. The rhetoric reached a fever pitch in late 2011 and the price of Bent topped out at $128 per barrel. It has since backed off as the reality of Europe’s banking and sovereign debt troubles have dominated more recent headlines tugging oil futures down. But, because of this many of the major oil producers have seen near-record earnings in 2011, like Petrobras (NYSE: PBR), ConocoPhilips (NYSE: COP), and BP (NYSE: BP).
But the pricing for oil is not only made up of these threats to supply. Global demand, after dipping in 2008 and 2009, has again resumed its uptrend. Consumption in 2010 topped 87 million barrels per day and the estimates for 2011 are 88.2 million barrels. There’s no reason to believe that consumption will slow down significantly even if there is further deterioration of the European banking system. Emerging market growth, while slowing slightly in places like Brazil and China are still rising on a per capita basis. The supply and demand characteristics are rising in concert. So, other than Iran what drove the price of Brent from $100 to $125 per barrel over the previous six months?
The same thing that drove the equity market rise in the U.S.: the open liquidity spigots between the 5 major central banks in November and the Swiss pegged the Franc to the Euro at 1.20 to 1. Modern markets are fueled by liquidity which central banks can only somewhat control. So, sabre rattling by the U.S. at Iran and a flood of money to stabilize banks during the Greek sovereign debt crisis created a massive run in the S&P 500, the DJIA and the price of oil.
The Petrodollar Defense
The main reason, in my opinion, that the U.S. is attacking Iran financially is not just about their gaining a nuclear weapon but defending the petrodollar system. There are two commodities in the world that are only priced in U.S. Dollars: gold and oil. All attempts to either price or trade oil in other currencies other have been met with extreme measures by the U.S.
The invasion of Iraq occurred because Saddam Hussein had signed deals to trade oil in euros. The Pan Asian Gold Exchange (PAGE) in Kunming, China was due to open in late 2011 offering a futures contract for gold that would be purchasable directly in Yuan. After a number of delays, sabotage and discussions behind the scenes that contract no longer has the backing of the People’s Bank of China and PAGE is essentially dead. Iran has been in the U.S.’s sights since it announced in 2009 that it was putting together an oil bourse to trade in any currency.
The dollar monopoly in oil and gold form two very powerful moats around the demand for U.S. Dollars: oil due to the sheer size of the market and gold because of currency status as inflation hedge and its symbolism of monetary stability.
For this article I went back and grabbed the daily closing price for Brent crude back to 1987 and, using a 288 day moving average as a proxy for the average price of Brent on any one day, constructed a day to day model of the size of the petrodollar market by multiplying that price by the daily worldwide oil import statistics (a proxy for international trade) for that year.
Today the daily demand for Dollars solely due to the international oil trade is $2.73 billion, which has nearly doubled since the announcement of the first round of quantitative easing. Iran is the world’s 4th producer and exporter of oil, exporting 2.52 million barrels of oil per day. At $120 per barrel Brent that represents, roughly, $315 million per day of the daily demand for dollars, or 11.5% of the total petrodollar trade in the world. If that trade were to leave the dollar there would be chaos as the Fed would have to absorb that stock of dollars at a time when they have their hands full with a $1.3 trillion U.S. budget deficit and European bank failures.
Currently everyone is scrambling to comply with the U.S.’s demands to cut off all trade with Iran. The National Defense Authorization Act, signed by President Obama on New Year’s Eve quarantined Iran’s central bank from international trade; a move that has caused hyperinflation of the Riel due to demand destruction and put anyone who continues to trade with Iran at risk of being barred from the U.S. banking system. Moreover, the U.S. has taken the unprecedented step of completely isolating Iran from the international commerce community by kicking their banks out of the international payment system, SWIFT.
The Next Set of Moves
In response a number of countries have voiced unwavering resistance to these measures by the U.S, including China, Russia and India; three of Iran’s biggest trading partners. India has stated that they will trade Iran everything from soybeans and washing machines to gold and Rupees to continue importing Iranian oil, moves that have enraged the U.S. State Department. As a matter of fact, India’s latest move was to remove all taxing barriers to the Rupees for oil trade. They did this during talks between India and the U.S. over this very issue during the week of April 2nd.
India will continue buying oil from Iran and use Rupees for 45% of the trade. At $120 per barrel Brent that represents $22 million per day that is no longer included in the U.S. petrodollar market, or just 0.8%. If we factor in the ‘junk for oil’ trade that Iran is also engaging in then that number rises to nearly $49 million, or 1.8%.
This may not seem like a big number, but if it wasn’t important then the U.S. would not be putting inordinate pressure on the rest of the world to heel. 0.8% of the petrodollar market is not that much, but the longer the situation is allowed to continue the less the petrodollar system resembles a prisoner’s dilemma for holders of dollars. That demand has to be soaked up by someone and foreign central banks have been slowing down their purchases of U.S. Treasuries.
Most countries that trade heavily with Iran are doing the bare minimum to stave off the ire of the U.S. Japan, Turkey and Korea were all granted exemptions because they reduced their trade by 10-15% and have shifted their purchases to other producers. The Saudis have increased production to compensate.
What happens after June 28th, when the sanctions are due to go into effect, if China and Russia refuse to stop trading with Iran? Does the U.S. invade at that point or is their bluff called? Does anyone not think that’s why Iran called for another round of talks in late May after this weekend’s session? Delaying tactics work against the U.S. and in Iran’s favor. Again this is not about the nuclear program as much as it is about setting up bilateral trade deals that can keep the oil flowing and weaken support for the dollar.
While removing Iran from SWIFT is a big deal it is also the last weapon the U.S. has other than outright military invasion. The signs are everywhere that countries are getting tired of being tied to the U.S. Dollar for everything: Brazil has called Bernanke a currency manipulator. The Swiss and the Germans are asking for audits of their sovereign gold holdings in New York. The BRICS nations are setting up a bank to conduct trade between themselves in their currencies. Will they open a commodities bourse too, or just support Iran’s in Kish? The MSCI BRICS ETF (NYSEMKT: BKF) is heavily weighted in energy at 23.8% of AUM. At the end of the day SWIFT is just a really powerful but convenient telephone system and easily replicated in the 21st century. Will Singapore or Hong Kong handle the transactions once Turkey, who has been handling India’s oil trades since December, stops? Someone will.
The End Game
The issue for the U.S. government is that the petrodollar system is the mechanism by which the spending orgy in Washington D.C. can continue. Look again at the chart above and notice how strongly the rising price of oil plays into the hands of the Federal Reserve’s desire to debase the dollar in order to goose exports. With the U.S. now a net exporter of petroleum products and production from the Bakken formation and others continuing to rise exponentially one could make a very strong argument that rising oil prices is exactly what policy makers in the U.S. want. This gives them a ready market for their dollars as well as their petroleum while exporting the inflation offshore to those they are supposedly friends with. With U.S. gasoline consumption plummeting U.S. GDP is becoming marginally less dependent on Brent.
As Jim Rickards pointed out recently, the Persians invented chess, and this game is one that has a lot of moves left in it. But the trends are unmistakable; the U.S. petrodollar system is going to end. How and when is anyone’s guess at this point? The U.S.’s military or industrial capacity are not its Achilles heel, its currency is. The more the current situation drags on the more comfortable everyone will be with the new normal. Avalanches do not have to start with an earthquake, sometimes a pebble will suffice.
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