Sunday, December 03, 2006

[the big three] shift in the hegemony

Russia

Russia, possessing unequalled energy-based leverage, has taken the leadership among the world's producers and the rising powerhouse economies of the East to promote a vast worldwide web of alliances and ties prominently featuring rigid bilateral, private long-term supply contracts.

This model runs counter to and increasingly circumvents the established liberal US-backed global oil market denominated in US dollars. The West relies on the current order for its energy security. It cannot function without it, and therefore the order is its single point of weakness. And Russia is acting as the "point man" to locate and exploit, with the help of its partners, this Achilles' heel of the West.

A conspicuous feature of global developments over the past several years is Russia's distinctive leadership role in fueling global transition in three key spheres - energy, economic and geopolitical.

Within six months of taking office as Russia's new president, Vladimir Putin was by the summer of 2000 already moving hard against the capitalist-inspired oligarchs who were fleecing Russia of its natural resources and industry with, at a bare minimum, the full complicity of the West.

Western institutions operating within Russia and those exercising what the Kremlin saw as undue influence from without, most notably the West's oil majors and their closely related financial institutions, certain non-governmental organizations and the media, have eventually either been pushed out or brought to heel.

Russia's strategic resources have been brought firmly under de facto Kremlin control in direct opposition to the West's loudly proclaimed liberal democratic principles of private ownership and control. Russia's example and success in such endeavors have instigated a global wave of nationalization and consolidation of state control over energy resources, with an accompanying loss of leverage and control by the West's oil majors. That wave is accelerating.

The rise of a powerful and wealthy resources-based corporate state in Russia ("sovereign democracy"), its rapidly expanding control over global strategic resources, and the resultant loss of leadership and control of the global oil market by the West's oil majors are developments that move directly against the very foundations of the US-led oil-market order and the wider US-centric global economic order. This is because Russia is quite literally fueling the rise of the powerhouse economies of the East and helping to achieve a new global center of economic power in the East.

It was also Russia that fundamentally led, along with its key partner China, the opposition to the US invasion of Iraq in 2003. It has been Russia first and foremost that has taken leadership among its strategic partners since then to continue to stand firm inside and outside the United Nations in a hugely successful strategy to force the full and mounting geopolitical, economic and military burdens of Iraq on to US and British shoulders alone.

Thereby, Russia has taken the lead in proving that the US-dominated geopolitical order can be successfully opposed. Consequently, it has clearly been primarily under Russia's leadership that the US-dominated global oil-market, global economic and geopolitical orders are being transformed, circumvented and opposed by growing numbers of the world's nations.

Against this backdrop, an impending, forcible shift of the US colossus out of its position of global dominance can be clearly seen, less as merely random and uncoordinated events, and more as a progressive coalescing of a coherent global strategy.

The new model
As indicated above, in a throwback to the 1970s, the comparatively more rigid bilateral long-term supply contract is making a significant comeback on oil markets. As Putin explained at the July Group of Eight summit: "We want to form a stable system of legal, political and economic relations that ensures a reliable demand and stable offer of energy resources on the international market."

Putin later complained at the Valdai Club meeting outside Moscow on September 9 that consuming nations in the West too strongly focussed on their own energy interests and security while simultaneously slighting the interests and security of producers. He noted that consuming nations wanted suppliers to pledge continuity of supplies for the long term, "so customers should not be able to turn around and say, 'We don't need it now.' Security works both ways. We need assurances, too."

Putin explicitly stated that Russia and other suppliers wanted bilateral long-term supply contracts with consuming nations so that suppliers would know there would be a stable demand for their exports.

The underlying, impending risk to the liquidity of the current oil order posed by such a throwback to the rigid bilateral long-term supply contract was highlighted recently in the testimony of David Goldwyn before the US House of Representatives Committee on Government Reform's Subcommittee on National Security, Emerging Threats and International Relations and the Subcommittee on Energy and Resources on May 16.

Goldwyn is senior fellow at the Center for Strategic and International Studies, a prestigious Washington, DC, think-tank, and president of Goldwyn International Strategies, a leading provider of political and business intelligence, energy-sector analysis and Washington strategy advice to Fortune 100 companies and investment advisers.

Goldwyn stated: "The United States is more energy-insecure today than it has been in nearly 30 years. We are insecure because the global oil market is more fragile, more competitive and more volatile than it has been in decades."

Goldwyn referred to the fact that "the growing [energy] dependence of rising powers such as China and India is rapidly eroding US global power and influence around the world" as those rising powers increasingly enter bilateral long-term contracts with suppliers, ever greater numbers of which do not allow free market access by the West's oil majors to production and exploration acreage and which are creating a strategically tight market for the rest of the world.

Goldwyn observed: "This 'tight' market is undermining the fluidity and fairness of the market for available oil supplies and exploration acreage. New competitors like China and India are trying to negotiate long-term supply contracts (at market prices) to ensure that they have supplies in the event of a crisis or supply disruption ... the trend is counter to the market system that operates so efficiently ... the trend of long-term contracts runs counter to the modern liquid global market which operates efficiently in rapidly moving supplies to meet market demand ... China has not yet developed faith in these market mechanisms."

While Goldwyn presented such concerns in the context of a rising but not yet imminent threat to the current order, in testimony before the US Senate Committee on Foreign Relations nearly a year earlier, on July 26, 2005, Mikkal Herberg of the National Bureau of Asian Research in Seattle, Senator Richard Lugar, the committee chairman, heard the following facts:

For China and India both, as well as the other Asian powers, energy is becoming a matter of "high politics" of national security and no longer just the "low politics" of domestic energy policy. Governments in both countries have decided that energy security is too important to be left entirely to the [US-led liberal] markets as their economic prosperity increasingly is exposed to the risks of global supply disruptions, chronic instability in energy exporting regions, and the vagaries of global energy geopolitics.

Both governments are responding to their growing sense of insecurity with a broad range of similar strategies regionally and globally to try to guarantee greater supply security and reduce their vulnerability to potential supply and price shocks. These efforts are growing in scale and scope and they range from largely cooperative and market oriented strategies to those that are deeply neo-mercantilist and competitive.

Both China and India are accelerating their efforts to gain more secure national control of overseas oil and gas supplies by taking equity stakes in overseas oil and gas fields, promoting development of new oil and gas pipelines to feed their booming markets, developing broader trade and energy ties, and following up with diplomatic ties to cement relations with the major oil and gas exporting countries.

And both governments sense they are excluded from the major institutions that govern global oil cooperation, such as the IEA [International Energy Agency], and feel largely excluded from the global oil industry they feel is dominated by the large oil companies from the industrial countries. Both feel they are playing "catch-up". For China's leaders, energy security clearly is too important to be left to the markets and so far its approach has been decidedly neo-mercantilist and competitive.

The term "neo-mercantilist" refers to the economic strategy and ideology pursued by the European colonial powers, wherein the natural resources and other wealth of the colonies that had been established by each colonial empire were rigidly dedicated exclusively to the sustenance of the mother empire.

In application to India, China and the other rising powers of the East, the term refers to the somewhat comparable strategy of concluding rigid, private bilateral long-term supply contracts between themselves individually and producers they each target around the globe. This has the net effect of securing oil and gas exclusively for the individual consumer state at the expense of the liquidity of the global oil market, and hence at the expense of oil's fungibility.

Herberg went on to make the case that China's three main state-owned oil companies (National Petroleum Corp, China Petroleum and Chemical Corp and China National Offshore Oil Corp) alone, by the latest data and estimates available more than a year ago, "have managed to establish control over about 300 mb/d [million barrels a day] of crude production, which could reach up to 600 mb/d by 2008".

Herberg went on to make the case that both China and India strengthen and solidify the exclusivity of such rigid long-term supply contracts with multiple layers of cross-investment and commercial ties between themselves and their producer partners, and with deepening diplomatic ties as well. The net effect is to shut out the free markets and Western oil majors and place rapidly growing portions of global supply under private lock and key. As Herberg noted:

China now [as of July 2005] has signed some form of "strategic energy partnership" with nine countries, including Russia, Sudan, Iran, Venezuela, Brazil, Angola and Kazakhstan. Beijing's leadership has followed up with a long list of high-level diplomatic visits to cement stronger diplomatic, energy and trade ties. China has also used state diplomacy to secure future LNG [liquefied natural gas] supplies in contracts with Australia, Indonesia and Iran.

China's leadership sees the development of broader diplomatic and trade ties and alliances as a key element in securing its access to future oil and gas supplies. This also includes military sales and cooperation, sales of nuclear equipment and other potentially problematic trade ties.

None of this includes the profoundly important strategic partnership agreement China signed with Saudi Arabia in January, nor its ever more wide-ranging energy-based agreements with the other Persian Gulf oil-and-gas-exporting states of Qatar, the United Arab Emirates, Kuwait and others around the globe. India also is pursuing a global strategy very similar to that of China. In July 2005, Herberg noted:

Currently, nearly two-thirds of the Gulf's oil exports go to Asia, and this will grow sharply in the future. The growing nexus of diplomatic, trade and military ties with China and India appeals to the Gulf producers who are looking to diversify their economic and geopolitical base beyond traditional dependence on the US and European markets and diplomatic relationships.

Herberg concluded with this assessment of the negative effects on the dynamism and liquidity of the US-led oil market:

Another area of concern involves a range of impacts of China and India's booming oil demand as well as the impact of their implied strategy of "locking up" national control of certain oil supplies to fuel their own economies, in effect, "taking oil off the market". Both countries clearly aim to lock up their own national oil supplies with many of their investments in places like Sudan and this practice is likely to contribute to higher oil prices and price volatility by reducing global market flexibility to handle tight markets, shortages and supply disruptions.

Exploiting the Achilles' heel

The economic (and consequently also the geopolitical) single point of failure for the highly industrialized nations of the West irrefutably is its continued unwavering global adherence to the liberal oil market that created and sustains oil-market supply fairness, liquidity, and oil's currently high level of fungibility.

The net effect of the (now former) global dominance and control of the West's oil majors over the lion's share of global energy resources was to ensure that those resources were irreversibly captured into the US-led market, thereby perpetuating the global dominance of that very order.

As such, the hemorrhaging of the dominance of West's oil majors to the current pitiful state that only 9% or 10% of global reserves are controlled by them represents a sea change. Where, that is, into which model, the lion's share of global energy resources will now be captured is no longer up to the West. That determination has already been forfeited to the rising East and the increasingly East-friendly producing regimes around the world, led by Russia. And nowadays the US depends on the market for nearly 60% of its energy needs.

In effect, the world is seeing the globe's energy resources increasingly divided between two rival, incompatible energy markets, one suffering loss of global support and becoming ever more slanted toward serving the energy needs only of the West, and the other enjoying mounting global support and fully serving the energy needs of all the rest.

Decisions of state-owned or state-controlled oil and gas companies such as that made known on October 9 respecting Russia's Gazprom, which has decided to exclude all foreign (notably Western) energy majors from its giant Shtokman gas project, or the recent decisions to threaten to revoke permanently the operating licenses of Western oil majors in the Sakhalin-1 and Sakhalin-2 projects, are representative of the wave of consolidation of control of global resources by state-owned and state-controlled energy companies around the world.

Such producing regimes, which display an ever greater self-assertiveness and an ever deepening political affinity with Russia and the East, are deciding to place a growing amount of their production into the Russian-led energy-market model rather than unwaveringly adhering to the US-led one.

The lucrative economic, financial, political and diplomatic package of enticements being offered to producers around the globe by China, India and the other economies of the East far outweigh what the US can offer - the US simply cannot compete. It cannot prevent, nor turn back, the steadily advancing global trend of the locking up of oil and gas by virtue of private, bilateral long-term supply contracts, and the mounting strategic control of oil and gas by state-owned enterprises. Its global leverage (and that of its oil majors) in the energy-rich regions of the world is severely contracting as a result.

The tentative decision announced recently by Putin to redirect from the US to Europe the gas production from the giant Shtokman project illustrates how such state-owned (or controlled) enterprises can turn on a dime. Today, they may sell their products on the established New York and London exchanges, but tomorrow they can switch away from this order to a growing number of alternatives, including the security of rigid bilateral long-term supply contracts.

Russia, China, India and the rest of the world outside the West have little fundamental attraction or loyalty to the US-supported global oil market or the governing institutions from which (such as the IEA and the Organization for Economic Cooperation and Development) they have largely been excluded. They do not feel an integral part of the global system they see as greedily and inordinately dominated by the multinational oil companies of the West, with which their relations are growing ever more tense. As such, they certainly cannot be expected to bolster the US-led model, and they are not doing so.

As the new Russian-led model locks up increasing amounts of oil and gas away from the global pool, that one virtual global pool of oil is increasingly being transformed from being a truly global one into a Western one. This revives the possibility of a targeted embargo because producers can decide to place less oil in the US-led system in favor of locking up more of their production into bilateral contracts with consumers in the East, and they can move rapidly to accelerate in that direction.

Professor Peter Odell, quoted in Part 1 of this report, alluded to this danger when he warned that Russia's oil grab presented an impending threat to the energy supplies of the West. The issue here is control of the production of oil and gas fields, and therefore where and to whom that production will be offered - within the open, liberal US-led model or within the rival, more rigid and private Russian-led one.

The global production and profits of the West's international oil majors are still very high. However, behind that facade of apparent market control and dominance lurks the specter of an impending, perhaps precipitous, collapse of the role and leverage of those oil majors the West relies on for its energy security.

In The Observer of London on October 29, in an article titled "Big oil may have to get even bigger to survive", the author notes that the West's international oil majors are in real trouble as regards the collapsing of their control over global energy reserves and face a global wave of nationalization, forced renegotiation of existing agreements, inability to get access to new exploration and production acreage and rising taxes. It is a caustic mix that is dissolving the glue that holds together the US-backed oil order.

As the oil majors produce oil for the market, they must replace their reserves. In 1997 they were able to replace 140% of their reserves, but in 2005 they were able to replace far less - only 75%. Consequently, they are rapidly shrinking while the state-owned companies around the globe are rapidly expanding as respects market dominance as measured by the crucial parameter of control of reserves.

Furthermore, the mounting global wave of oil-sector nationalization that is pushing international oil majors on to the sidelines as respects control of reserves could easily and quickly take an even more ominous turn - cutting significantly into the current production capabilities of the oil majors and placing the energy security of the US in acute jeopardy.

Assumptions that such a scenario deserves little worry and attention are not valid or safe in the environment of ever more nationalistic leanings on the part of the oil-producing regimes around the globe and the specter of forced renegotiations of PSAs (production sharing agreements) and cancellations of operating licenses.

What applies to production acreage also applies to exploration acreage, and access to and control over both are being massively forfeited by the West and its oil majors. Foreign investment in energy-producing enterprises and acreage is being severely restricted as a result, and this ensures strategically tight global supply, further exacerbating the mounting energy security misfortunes of the West. This is because in the absence of abundant global supply the West has no viable means to counteract the locking up of increasing amounts of the global supply by Russia's new model.

Attack on dollar dominance
As if these developments were not bad enough for Western strategic energy security, another key development has arisen, one that gravely threatens not only to diminish further the energy security of the West, but also in effect to put an end to its global economic and geopolitical dominance by credibly threatening to crash the US dollar.

This additional key development is the planned and actual proliferation of new oil/gas market exchanges denominated in currencies other than US dollars.

The new Russian-led concept of "international" energy security and its new model for the global market do not consist merely of long-term supply contracts alone. Planned oil- and gas-market exchanges are being set up not to bolster the current London and New York exchanges, but to stand separate and distinct from, to compete with, them to rival the US-led order.

The new exchanges are either being originally set up to settle transactions in currencies other than the US dollar, or they are being created with the sophistication and autonomy to enable them to switch from US dollars to virtually any other desired currency (or to multiple currencies) when developments might warrant such a switch.

That fact implies the draining of significant portions of the one global dollar-denominated pool of oil to fill the new pools denominated in other currencies, thereby fragmenting from the current global pool (and from the US-led order itself) significant portions of the global supply to fill the new pools. Such fragmentation will in effect put an end to the current order, which has dominated for barely two decades.

The new Shanghai Petroleum Exchange settles transactions in the Chinese currency, the yuan. Russia's new St Petersburg exchange, slated to come online next year, will settle transactions in the ruble. According to Russian Economy Minister German Gref, Russian products will be offered on the New York exchange until the St Petersburg exchange is operational, at which time Russian products will be shifted out of the New York exchange to the Russian exchange.

Qatar's new Energy City concept with its integrated IMEX (International Mercantile Exchange), which India has recently joined with the planned creation of a satellite Energy City/IMEX complex in Mumbai, will apparently settle transactions initially in the US dollar, with the capability to switch to other currencies. The IMEX is a fully autonomous system predominantly designed and intended to capture the rising energy markets in the East.

Prudently, Arab oil and gas exporters are leveraging IMEX to work to achieve full autonomy as respects market and exchange operations and product pricing and delivery, foreseeing the day when having their operations constrained almost completely under the aegis of the Anglo-US market arrangement and the US dollar no longer serves their strategic interests.

The logical question at this juncture is whether these new exchanges can successfully compete any time soon with those in New York and London. Assuming those creating the new exchanges do not lose their nerve and back down from establishing them as working, autonomous entities, as Iran apparently has backed down from its planned oil bourse denominated in the euro, the answer to that question is fundamentally the same as asking whether there exists enough global supply margin for importing nations to be able to ignore the new exchanges.

In the very tight global supply situation we find ourselves locked into, importing nations will have little choice but to go wherever oil and gas are available to fill their needs. If the new exchanges rob significant portions of oil from the current one global pool as is planned, then the new exchanges will not need to be concerned about adequate consumer interest, support and devotion.

And global producers are assuredly going to do all that is needed to keep the global supply tight and the price of oil elevated to avoid a global oil glut and a price collapse. Continued tight supply will help to ensure the success of the new exchanges.

Furthermore, the fact that the West's oil majors have lost control of all but 9% or 10% of reserves means that state-controlled oil companies can reroute any amount of product they wish from the New York-London exchanges to any of the new exchanges. This will provide a more than sufficient supply to guarantee the success of the new exchanges, and the US can do nothing to stop it.

As this happens, the prospect of a targeted embargo of the West is revived. Producers will be able to restrict the amount of oil they sell on the London-New York exchanges, or cease selling there altogether, because they will have viable, even preferred, alternative exchanges. That will seriously endanger the amount of supplies accessible to the West and will radically drive up the price of oil on the dollar-denominated exchanges. But because all of the new and planned exchanges will have their own non-dollar pricing mechanisms, the undesirable price volatility will tend to be confined to the dollar-denominated exchanges.

What happens to the US dollar as the new exchanges become operational and begin to be successful? The exit from the dollar as the international currency will have begun in earnest. But that exit will not be to one currency, but simultaneously to the several currencies that are the denomination currencies of all the successful new oil and gas market exchanges.

The dollar will begin to weaken as its international support and devotion wanes, or even sinks. As the dollar weakens, the price in dollars for everything the US imports will skyrocket, adding a powerful inflationary hit to the US economy. Along with the impending US recession, that will further weaken the dollar and likely its decline, or outright collapse, will feed on itself.

As the dollar weakens and energy price volatility increases on the New York-London exchanges, producers will have further powerful incentive to switch their product offering to the non-dollar-denominated exchanges, where there will be greater stability and where they will not be forced to take payment for their products in the increasingly undesirable weakened dollar.

The profound risks to the West as respects its ability then to secure access to sufficient energy resources should be self-evident. Left with a severely shrunken dollar-denominated pool of oil and gas, a pool that virtually only the West draws from, the viability of a potential targeted embargo will have increased exponentially.

The globe's producers will be fully able to "throttle" the economies of the West by virtue of controlling how much of their oil and gas they sell into the dollar-denominated pool. This represents the nightmare scenario for the US.

Perhaps the most disturbing aspect of this analysis is the fact that it is not based on any hypothetical conspiracy theory, but rather on solid economic and market principles and the increasingly ominous warnings of experts and informed leaders.

Additionally, the key developments that are already pushing the world order to the eventuality described here, that of a full exploitation of the West's Achilles' heel by Russia and its global partners leading to a loss of the US global position of economic and geopolitical dominance, are already well established.

Russia, in conceiving the new model of "international" energy security and a new global energy order, and in winning increasing numbers of key converts and adherents to its model, thereby defines and draws the circle of international energy security. Those inside the circle will achieve Russia's definition of "energy security", but those left outside will be left with little if any energy security by any definition.

2006

W Joseph Stroupe is author of the new book Russian Rubicon: Impending Checkmate of the West and editor of Global Events Magazine, online at www.GeoStrategyMap.com.