by W. Joseph Stroupe

22-11-06

Russia has found the Achilles' heel of the US colossus.
In concert with its oil-producing partners and the rising powerhouse economies of the East, Russia is altering the foundations of the current US-led liberal global oil-market order, insidiously working to undermine its US-centric nature and slanting it toward serving first and foremost the energy-security needs and the geopolitical aspirations of the rising East.

All this is at the impending incalculable expense of the West. What is increasingly at stake is secure US access to global energy resources -- strategic US energy security -- because the West's traditional control respecting those global resources is seriously faltering in the face of the compelling strategies undertaken by Russia and its global partners.
The US giant is increasingly at risk as it faces what is gradually but now more widely being recognized as Russia's clever exploitation of US foreign energy dependency and the haemorrhaging of its all-important economic-geopolitical capital: its traditional global energy leadership and dominance via its onetime virtually all-pervasive oil majors.

US Senator Richard Lugar, who recently labelled Russia an "adversarial regime" that increasingly uses its growing energy dominance as a powerful geopolitical weapon, has warned of economic "catastrophe" for the United States, notwithstanding its status as a superpower. Consequently, informed and reasoned leaders such as Lugar increasingly see the US in energy-based jeopardy.
Such leaders clearly do not put blind trust in the conventional wisdom that keeps insisting the US giant has no Achilles' heel and is virtually immune to the efforts on the part of comparatively smaller powers such as Russia and its partners to undermine the current US global position of supremacy.

Backing up the mounting concerns of such leaders as Lugar, as reported on October 1, widely respected energy economist Professor Peter Odell, who was an adviser to Tony Benn, the British energy minister in the late 1970s, and who has since worked for a host of different foreign governments, said he was not being alarmist or controversial when he recently warned that the West was at imminent risk of losing access to global energy resources as a result of Russia's global oil grab.
Odell warned that at any time Russian and Chinese state-owned oil companies, backed by certain rich members of the Organization of Petroleum Exporting Countries who are closely aligned with the two, could make hostile takeover bids for key Western oil majors such as BP-Shell, ExxonMobil and/or Chevron, thereby gutting what little remains of the Western oil majors' control over the global markets and thereby further threatening US access to strategic resources.

Odell warned that the Western oil majors were already losing their leadership of the global oil system, had now been reduced to controlling a mere 9 % or 10 % of the world's reserves, and were unable to win new production rights or even hold on tothose granted by current PSAs (production-sharing agreements).
Recent developments regarding Russia's Sakhalin-I and Sakhalin-II projects, in which the position of the Western oil majors is being threatened, illustrate the ominous trend that is accelerating worldwide.

To rock the US colossus forcefully out of its position of global dominance and credibly threaten to inflict economic and geopolitical "catastrophe" on the West, Russia and its strategic partners need not exceed, nor individually even remotely match, US economic, political or military strength in a conventional head-to-head contest of might.
Instead, they need only to exert effectively their mounting energy-based strengths against US vulnerabilities in that same sphere, not in a conventional head-on confrontation but instead by going after the Achilles' heel by employing a clever asymmetrical end-run strategy around the US.

This targets the foundations of the current US-dominated liberal global oil-market order, a strategy that leaves the US giant with significantly reduced secure access to, and control over, global strategic resources.
Once that goal is accomplished, without ever a conventional confrontation with the US giant, then the US economy can be effectively and powerfully held hostage to the political and economic aspirations of Russia and the rising East.

Conventional wisdom holds that neither the West in general nor the US in particular can be effectively targeted with the energy weapon any time soon. This is because the structure of the global oil market prevents targeted oil embargoes from being effective. Once oil is sold on the global market, no producer can control where it does or does not go, the argument says. Additionally, the argument continues, producers attempting an embargo cannot afford to withhold their products for long enough to damage the targeted economy lest their own economies, which are inordinately dependent on oil and gas exports, themselves collapse.
The clear insinuation is that any talk of an energy-based economic checkmate of the West is merely hyperbole and sensationalism.

But these arguments are already in the process of collapsing under their own weight in the face of an entirely new array of mounting trends and developments that constitute an impending and grave threat to the strategic energy security of the West.
In its recent report "National Security Consequences of US Oil Dependency", the US Council on Foreign Relations disagrees with such reassuring conventional wisdom and the myths and assumptions associated with it. It warns that the US faces increasingly potent, negative political, economic and geopolitical consequences arising from its dependence on foreign energy resources. The report laments that the US is "insufficiently aware of its vulnerability" because its leaders and people have come to rely on reassuring myths and assumptions that do not sq with the facts.

To understand why the conventional wisdom on this issue has become severely faulted and how Russia and its partners are already ominously succeeding in altering the fundamentals of the current US-dominated global oil-market order, it is first necessary to understand how the current oil markets work and how they have evolved over the past three decades since the Arab oil embargo of 1973-74.

Changing the world's oil markets
In the era leading up to the embargo of 1973-74, crude-oil pricing and delivery were handled quite differently than now. That era featured the rigid, bilateral long-term supply contract resulting in considerably less global oil-market supply liquidity than now. It was an era when exporting states tended to conclude agreements individually with consumer states (usually through their national and multinational oil companies) over the price and delivery of crude oil.
Such contracts could be concluded for terms of one or two decades or even more. In that era of rigid bilateral oil contracts, the oil market was much less open and dynamic, and far less able to adjust to supplydisruptions, than it is now. Oil tended to be "locked up" within the long-term supply contracts, thus significantly limiting supply liquidity, or fungibility, of oil.

The structure of the global oil market was neither designed nor implemented with a focus on the key requirement of high liquidity because, prior to the 1973-74 Arab embargo, no one envisaged the now-obvious key requirement for the market to adjust rapidly and naturally to a cut-off of oil to one or more importing nations resulting from a targeted embargo or a supply disruption.
Naturally, in that era it was in the interest of any individual exporting state to conclude a sufficient number of rigid bilateral long-term contracts with importing states so as to have most or all of its exportable oil accounted for and sold virtually at the time it was pumped out of the ground.

That being the usual case, if an exporting state or group of states for some reason either failed or refused to honour their commitment of deliveries to a particular consumer state, then that embargoed state found it necessary to meet the emergency by trying to acquire replacement crude-oil supplies from elsewhere, usually from third-party traders and/or by arranging with other buyers for their tankers to be diverted from their original destinations.
That ad hoc process involved many additional, intolerable risks, time delays, and much more complicated logistics and higher costs, all of which were entirely unacceptable over a period of anything more than the very short term. The old oil-market order did not naturally facilitate a compensating for such a supply disruption, and the effort to make it compensate was cumbersome and its risks were unacceptable.

Additionally, the psychological effects of an embargo greatly magnified its literal effects, leading to panic buying by consumers, resulting shortages, higher prices and ripple effects throughout the economy. That helps explain why the US could be effectively targeted in 1973-74 by the Arabs. Though that targetingwas not nearly perfect, it was sufficient to inflict much of the intended pain.
As the months wore on, the US could not afford to continue to rely on the intolerable and significantly less secure ad hoc logistics it was forced to resort to in its effort to replace the oil that the Arab nations were refusing to ship. Recently declassified British government documents from that time reveal that both the US and Britain were actively planning for a seizure of Middle East oilfields, illustrating how intolerable the combined physical and psychological effects of the embargo were.

Of note is the ominous fact that at that time the US imported only about 36 % of its oil, whereas now it imports nearly 60 %, making it far more vulnerable to the energy weapon if Russia and its partners only partially succeed in changing the current liberal global oil order so as to revive even a partial level of effectiveness of a targeted embargo.

US and Britain create a liberalized market
In the aftermath of the 1973-74 crisis, events and the markets themselves gradually evolved to alter radically the nature of the global oil market, thereby dramatically increasing crude oil's former comparatively low degree of fungibility.
This means that as long as the current US-backed liberal oil market is globally adhered to, if a group of exporting nations attempts another targeted embargo, oil from other exporters could be rapidly and naturally exchanged or substituted to replace the lost oil. The global market has evolved from rigidity to dynamism, and from low to very high liquidity.

Over time, the US had come up with an ingenious idea that impacted directly on the issue. Through deregulation and the creation of oil-futures contracts and spot oil markets in New York and London, the old foundations and the market dominance of the rigid, bilateral long-term supply contracts was undermined in favour of much shorter-term contracts.
Extremely liquid oil-futures contracts ("paper oil") that looked forward only a few months to a few years at most and that could be freely and openly bought and sold on a daily basis on the new exchanges replaced the traditional, rigid, discrete long-term supply contracts negotiated directly between exporting and importing states. The global oil-market order was becoming tremendously liberalized, open and highly liquid under US leadership and control.

The new oil exchanges created in the early 1980s provided a way for speculators to profit from the buying and selling of "paper oil" as well as for exporters and importers to sell, buy and arrange for physical delivery of oil. The spot exchanges also facilitated the factoring in of a much wider range of market forces in real time in determining the daily global price of oil. Oil-export start-ups, those attempting to establish themselves as oil exporters, favoured the spot markets as opposed to the rigid long-term supply contracts because, with their limited track record and credibility, they had a hard time successfully negotiating long-termcontracts.
However, they could sell on the spot markets by undercutting the price of the more established exporters and get a foothold. Thus the new arrangement encouraged a flourishing of new exporters and a global supply that very comfortably outpaced global demand.

By the mid- to late 1980s, the new oil-market arrangements in New York (and later in London) had been firmly established and were enjoying phenomenal success. While some exporters refused to drop entirely the traditional rigid bilateral long-term supply contracts in favour of the spot markets, up until today most oil is marketed on the exchanges.
Oil-futures contracts are freely bought and sold on the exchanges and oil for physical delivery is bought comparatively "at the last hour" on the spot market, where delivery to the importing nation is then arranged.

Global effects of the new order
Under the new market arrangement, nearly all oil became highly visible and instantly accessible because the traditional long-term supply contracts became the minor factor while the spot markets and highly liquid oil-futures contracts became the major factors. In effect, this radically raised the visibility, accessibility and fungibility of global oil supplies to unheard-of heights and made it possible for oil lost for some reason in one part of the market to be easily, naturally and almost instantly replaced by oil from another part of the market.
In effect, the new exchanges facilitated the creation of one virtual global pool of oil denominated in dollar into which nearly all exporters sell their oil and out of which nearly all importers purchase oil, all on a daily basis.

A discrete global pool of oil does not physically exist anywhere on the planet, of course. But it does exist in a virtual sense, powerfully mimicking a literal global pool of oil, because the structure and presence of the new exchanges and the global adherence and devotion to them ensures that oil is bought, sold and delivered largely as if such a pool literally exists. And the global dominance of the West's oil majors, whose task it has been to capture global oil supplies for full incorporation into the new US-led liberal global oil-market order, has been the key factor perpetuating the global dominance of that order.
As long as the Western oil majors hold global sway and the US-backed liberal order is globally adhered to, therefore, any attempt to target the US with an oil embargo, as by the efforts of an exporter or group of exporters refusing to sell to the US, would fail miserably because the US would merely draw oil elsewhere from the global pool to suffice its needs.

Importantly, the US and Britain accomplished two goals of profound importance and value with the creation of their new liberalized global oil-market order.
First, they prevented the enacting of any targeted oil embargo, and they greatly enhanced the leverage of the West's oil majors, their de facto state sponsors and the West's financial institutions in the new market arrangement while simultaneously fundamentally undermining the leverage of producers, thus powerfully bolstering the strategic energy security of the West.
Second, they consolidated and powerfully solidified the role of the dollar as the unquestioned international currency, since the one virtual global pool of oil created and maintained by the new liberalized market order is denominated in dollar alone.

But it is crucial to understand that the West's immunity from a targeted embargo is assured only as long as the current liberal, highly liquid US-led global oil market is unwaveringly adhered to. Once the movers and shakers (now Russia and its producing and consuming partners) begin again to revert to the rigid bilateral long-term supply contracts conducted privately between producers and consumers, thereby incrementally altering the foundations of the global oil-market order by decreasing its level of liquidity, then the real potential for a revoking of a significant measure of oil's fungibility exists.
This means that the ability to enact an effective targeted embargo is once again incrementally revived. A meaningful loss of fungibility of oil would spell potential economic-geopolitical doom for the West. This is the Achilles' heel of the West.

As we shall see, it is that very Achilles' heel Russia and its partners have found and are already energetically exploiting in a bid to shift the US colossus out of its current position of global dominance. Swiftly mounting anxiety on the part of increasing numbers of the globe's key energy-hungry economies in the East as respects energy security is already fuelling incremental abandonment and circumvention of the US-dominated liberal global oil market.
This is in favour of a proliferation of private, state-to-state long-term supply contracts and agreements awarding equity stakes in production acreage to the consumer states. As a consequence, the US-led order is already beginning to suffer a wavering of international adherence and support. Russia continues to lead the global race to establish a new energy order that fundamentally threatens the current US-led one.

The same factor of mounting anxiety over energy security is also fuelling the accelerating global trend toward the establishment of new oil and gas exchanges in the Middle East and the East as de facto rivals to the New York and London exchanges.
These new exchanges have two very prominent and significant features. First, they are bringing together primarily the globe's producers and the rising economies in the East to facilitate new Asia-centric (rather than US-centric) energy pricing and security arrangements. Second, they are denominated in currencies other than dollar or are being structured with the autonomy and sophistication to switch from dollars to other currencies.

The reign of the US-backed current oil market has been a frighteningly short one, barely two decades. It could turn out to be more of a stint than a reign as its fundamentals could be altered to revive the possibility of an effective targeted embargo.
And it is already being altered along those lines.

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.