Hypothesizing on the Iran-Russia-U.S. Triangle

By George Friedman ~ Honorary Political Season Contributor

A Net Assessment Re-examined

For the past several weeks, STRATFOR has focused on therelationship between Russia and Iran. As our readers will recall, a pro-Rafsanjani demonstration that saw chants of “Death to Russia,” uncommon in Iran since the 1979 revolution, triggered our discussion. It caused us to rethink Iranian President Mahmoud Ahmadinejad’s visit to Russia just four days after Iran’s disputed June 12 presidential election, with large-scale demonstrations occurring in Tehran. At the time, we ascribed Ahmadinejad’s trip as an attempt to signal his lack of concern at the postelection unrest. But why did a pro-Rafsanjani crowd chant “Death to Russia?” What had the Russians done to trigger the bitter reaction from the anti-Ahmadinejad faction? Was the Iranian president’s trip as innocent as it first looked?

At STRATFOR, we proceed with what we call a “net assessment,” a broad model intended to explain the behavior of all players in a game. Our net assessment of Iran had the following three components:

1. Despite the rhetoric, the Iranian nuclear program was far from producing adeliverable weapon, although a test explosion within a few years was a distinct possibility.
2. Iran essentially was isolated in the international community, with major powers’ feelings toward Tehran ranging from hostile to indifferent. Again, rhetoric aside, this led Iran to a cautious foreign policy designed to avoid triggering hostility.
3. Russia was the most likely supporter of Iran, but Moscow would avoid becoming overly involved out of fears of the U.S. reaction, of uniting a fractious Europe with the United States and of being drawn into a literally explosive situation. The Russians, we felt, would fish in troubled waters, but would not change the regional calculus.

This view — in short, that Iran was contained — remained our view for about three years. It served us well in predicting, for example, that neither the United States nor Israel would strike Iran, and that the Russians would not transfer strategically significant weapons to Iran.

A net assessment is a hypothesis that must be continually tested against intelligence, however. The “Death to Russia” chant could not be ignored, nor could Ahmadinejad’s trip to Moscow.

As we probed deeper, we found that Iran was swirling with rumors concerning Moscow’s relationship with both Ahmadinejad and Ayatollah Ali Khamenei. Little could be drawn from the rumors. Iran today is a hothouse for growing rumors, and all our searches ended in dead ends. But then, if Ahmadinejad and Khamenei were engaging the Russians in this atmosphere, we would expect rumors and dead ends.

Interestingly, the rumors were consistent that Ahmadinejad and Khamenei wanted a closer relationship to Russia, but diverged on the Russian response. Some said the Russians already had assisted the Iranians by providing intelligence ranging from Israeli networks in Lebanon to details of U.S. and British plans to destabilize Iran through a “Green Revolution” like the color revolutions that had ripped through the former Soviet Union (FSU).

Equally interesting were our Russian sources’ responses. Normally, they are happy to talk, if only to try to mislead us. (Our Russian sources are nothing if not voluble.) But when approached about Moscow’s thinking on Iran, they went silent; this silence stood out. Normally, our sources would happily speculate — but on this subject, there was no speculation. And the disciplined silence was universal. This indicated that those who didn’t know didn’t want to touch the subject, and that those who did know were keeping secrets. None of this proved anything, but taken together, it caused us to put our net assessment for Iran on hold. We could no longer take any theory for granted.

All of the foregoing must be considered in the context of the current geopolitical system. And that is a matter of understanding what is in plain sight.

Potential Russian Responses to Washington

The U.S.-Russian summit that took place after the Iranian elections did not go well.U.S. President Barack Obama’s attempt to divide Russian President Dmitri Medvedev and Russian Prime Minister Putin did not bear fruit. The Russians were far more interested in whether Obama would change the FSU policy of former U.S. President George W. Bush. At the very least, the Russians wanted the Americans to stop supporting Ukraine’s and Georgia’s pro-Western tendencies.

But not only did Obama stick with the Bush policy, he dispatched U.S. Vice President Joe Biden to visit Ukraine and Georgia to drive home the continuity. This was followed by Biden’s interview with The Wall Street Journal, in which he essentially said the United States does not have to worry about Russia in the long run because Russia’s economic and demographic problems will undermine its power. Biden’s statements were completely consistent with the decision to send him to Georgia and Ukraine, so the Obama administration’s attempts to back away from the statement were not convincing. Certainly, the Russians were not convinced. The only conclusion the Russians could draw was that the United States regards them as a geopolitical cripple of little consequence.

If the Russians allow the Americans to poach in what Moscow regards as its sphere of influence without responding, the Russian position throughout the FSU would begin to unravel — the precise outcome the Americans hope for. So Moscow took two steps. First, Moscow heated up the military situation near Georgia on the anniversary of the first war, shifting its posture and rhetoric and causing theGeorgians to warn of impending conflict. Second, Moscow increased its strategic assertiveness, escalating the tempo of Russian air operations near the United Kingdom and Alaska, and more important, deploying two Akula-class hunter-killer submarines along the East Coast of the United States. The latter is interesting, but ultimately unimportant. Increased tensions in Georgia are indeed significant, however, since the Russians have decisive power in that arena — and can act if they wish against the country, one Biden just visited to express American support.

But even a Russian move against Georgia would not be decisive. The Americans have stated that Russia is not a country to be taken seriously, and that Washington will therefore continue to disregard Russian interests in the FSU. In other words, the Americans were threatening fundamental Russian interests. The Russians must respond, or by default, they would be accepting the American analysis of the situation — and by extension, so would the rest of the world. Obama had backed the Russians into a corner.

When we look at the geopolitical chessboard, there are two places where the Russians could really hurt the Americans.

One is Germany. If Moscow could leverage Germany out of the Western alliance, this would be a geopolitical shift of the first order. Moscow has leverage with Berlin, as the Germans depend on Russian natural gas, and the two have recently been working on linking their economies even further. Moreover, the Germans are as uneasy with Obama as they were with Bush. German and American interests no longer mesh neatly. The Russians have been courting the Germans, but a strategic shift in Germany’s position is simply not likely in any time frame that matters to the Russians at this juncture — though the leaders of the two countries are meeting once again this week in Sochi, Russia, their second meeting in as many months.

The second point where the Russians could hurt the Americans is in Iran. An isolated Iran is not a concern. An Iran with a strong relationship to Russia is a very different matter. Not only would sanctions be rendered completely meaningless, but Iran could pose profound strategic problems for the United States, potentially closing off airstrike options on Iranian nuclear facilities.

The Strait of Hormuz: Iran’s Real Nuclear Option

The real nuclear option for Iran does not involve nuclear weapons. It would involve mining the Strait of Hormuz and the narrow navigational channels that make up the Persian Gulf. During the 1980s, when Iran and Iraq were at war, both sides attacked oil tankers in the Persian Gulf. This raised havoc on oil prices and insurance rates.

If the Iranians were to successfully mine these waters, the disruption to 40 percent of the world’s oil flow would be immediate and dramatic. The nastiest part of the equation would be that in mine warfare, it is very hard to know when all the mines have been cleared. It is the risk, not the explosions, which causes insurance companies to withdraw insurance on vastly expensive tankers and their loads. It is insurance that allows the oil to flow.

Just how many mines Iran might lay before being detected and bringing an American military response could vary by a great deal, but there is certainly the chance that Iran could lay a significant number of mines, including more modern influence mines that can take longer to clear. The estimates and calculations of minesweepers — much less of the insurers — would depend on a number of factors not available to us here. But there is the possibility that the strait could be effectively closed to supertankers for a considerable period. The effect on oil prices would be severe; it is not difficult to imagine this aborting the global recovery.

Iran would not want this outcome. Tehran, too, would be greatly affected by the economic fallout (while Iran is a net exporter of crude, it is a net importer of gasoline), and the mining would drive the Europeans and Americans together. The economic and military consequences of this would be severe. But it is this threat that has given pause to American and Israeli military planners gaming out scenarios to bomb Iranian nuclear facilities. There are thousands of small watercraft along Iran’s coast, and Iran’s response to such raids might well be to use these vessels to strew mines in the Persian Gulf — or for swarming and perhaps even suicide attacks.

Notably, any decision to attack Iran’s nuclear facilities would have to be preceded by (among other things) an attempt to neutralize Iran’s mine-laying capability — along with its many anti-ship missile batteries — in the Persian Gulf. The sequence is fixed, since the moment the nuclear sites are bombed, it would have to be assumed that the minelayers would go to work, and they would work as quickly as they could. Were anything else attacked first, taking out the Iranian mine capability would be difficult, as Iran’s naval assets would scatter and lay mines wherever and however they could — including by swarms of speedboats capable of carrying a mine or two apiece and almost impossible to engage with airpower. This, incidentally, is a leading reason why Israel cannot unilaterally attack Iran’s nuclear facilities. They would be held responsible for a potentially disastrous oil shortage. Only the Americans have the resources to even consider dealing with the potential Iranian response, because only the Americans have the possibility of keeping Persian Gulf shipping open once the shooting starts. It also indicates that an attack on Iran’s nuclear facilities would be much more complex than a sudden strike completed in one day.

The United States cannot permit the Iranians to lay the mines. The Iranians in turn cannot permit the United States to destroy their mine-laying capability. This is the balance of power that limits both sides. If Iran were to act, the U.S. response would be severe. If the United States moves to neutralize Iran, the Iranians would have to push the mines out fast. For both sides, the risks of threatening the fundamental interests of the other side are too high. Both Iran and the United States have worked to avoid this real “nuclear” option.

The Russian Existential Counter

The Russians see themselves facing an existential threat from the Americans. Whether Washington agrees with Biden or not, this is the stated American view of Russia, and by itself it poses an existential threat to Russia. The Russians need an existential counterthreat — and for the United States, that threat relates to oil. If the Russians could seriously threaten the supply of oil through the Strait of Hormuz, the United States would lose its relatively risk-free position in the FSU.

It follows from this that strengthening Iran’s ability to threaten the flow of oil, while retaining a degree of Russian control over Iran’s ability to pull the trigger, would give Russia the counter it needs to American actions in the FSU. The transfer of more advanced mines and mining systems to Iran — such as mines that can be planted now and activated remotely (though most such mines can only lay, planted and unarmed, for a limited period) to more discriminating and difficult-to-sweep types of mines — would create a situation the Americans could neither suppress nor live with. As long as the Russians could maintain covert control of the trigger, Moscow could place the United States, and the West’s economies, in check.

Significantly, while this would wreak havoc on Persian Gulf producers and global oil consumers at a time when they are highly vulnerable to economic fluctuations, a spike in the price of oil would not hurt Russia. On the contrary, Russia is an energy exporter, making it one of the few winners under this scenario. That means the Russians can afford much greater risks in this game.

We do not know that the Russians have all this in mind. This is speculation, not a net assessment. We note that if Russo-Iranian contacts are real, they would have begun well before the Iranian elections and the summit. But the American view on Russia is not new and was no secret. Therefore, the Russians could have been preparing their counter for a while.

We also do not know that the Iranians support this Russian move. Iranian distrust of Russia runs deep, and so far only the faction supporting Ahmadinejad appears to be playing this game. But the more the United States endorses what it calls Iranian reformists, and supports Rafsanjani’s position, the more Ahmadinejad needs the Russian counter. And whatever hesitations the Russians might have had in moving closer to the Iranians, recent events have clearly created a sense in Moscow of being under attack. The Russians think politically. The Russians play chess, and the U.S. move to create pressure in the FSU must be countered somewhere.

In intelligence, you must take bits and pieces and analyze them in the context of the pressures and constraints the various actors face. You know what you don’t know, but you still must build a picture of the world based on incomplete data. At a certain point, you become confident in your intelligence and analysis and you lock it into what STRATFOR calls its net assessment. We have not arrived at a new net assessment by any means. Endless facts could overthrow our hypothesis. But at a certain point, on important matters we feel compelled to reveal our hypothesis not because we are convinced, but simply because it is sufficiently plausible to us — and the situation sufficiently important — that we feel we should share it with the appropriate caveats. In this case, the stakes are very high, and the hypothesis sufficiently plausible that it is worth sharing.

The geopolitical chessboard is shifting, though many of the pieces are invisible. The end may look very different than this, but if it winds up looking this way, it is certainly worth noting.

Falling Fortunes, Rising Hopes and the Price of Oil

Oil prices have now dipped — albeit only briefly — below US$40 a barrel, a precipitous plunge from their highs of more than US$147 a barrel in July. Just as high oil prices reworked the international economic order, low oil prices are now doing the same. Such a sudden onset of low prices impacts the international system just as severely as recent record highs.

But before we dive into the short-term (that is, up to 12 months) impact of the new price environment, we must state our position in the oil price debate. We have long been perplexed about the onward and upward movement of the oil markets from 2005 to 2008. Certainly, global demand was strong, but a variety of factors such as production figures and growing inventories of crude oil seemed to argue against ever-increasing prices. Some of our friends pointed to the complex world of derivatives and futures trading, which they said had created artificial demand. That may well have been true, but the bottom line is that, based on the fundamentals, the oil numbers did not make a great deal of sense.

Things have clarified a great deal of late. We are now facing an environment in which the United States, Europe and Japan are in recession, while China is, at the very least, expecting to see its growth slow greatly. Demand for crude the world over is sliding sharply even as the Organization of the Petroleum Exporting Countries (OPEC) member states so far seem unable (or, in the case of Saudi Arabia, perhaps unwilling) to make the necessary deep cuts in output that might halt the price slide. The bottom line is that, while the breathtaking speed at which prices have collapsed has caught us somewhat by surprise, the direction and the depth of the plunge has not.

Prices are likely to remain low for some time. Most of the world’s storage facilities — such as the U.S. Strategic Petroleum Reserve — are full to the brim, so large cuts are needed simply to prevent massive oversupply. Yet any OPEC production cuts — the cartel meets Dec. 17 and deep cuts are expected — will take months to have a demonstrable impact, especially in a recessionary environment. And there is the simple issue of scale. The global oil market is a beast: Total demand at present is about 86 million barrels per day. This is not a market that can turn on a dime. A firm fact that flies in the face of conventional wisdom is that oil actually falls far faster than it rises when the fundamentals are out of whack. This has happened on multiple occasions, and not that long ago.

Falls occurred both in the aftermath of the 1990-1991 Persian Gulf War and as a result of the 1997-1998 Asian financial crises that were similar in percentage terms to the present drop. Until the balance between supply and demand is restruck — something not likely until a global economic recovery is well under way — there is no reason to expect a significant price recovery. The journey, of course, is not necessarily a one-way trip. Quirks in everything from weather to shipping to Nigerian riots and Russian military movements can set prices gyrating, but the fundamentals are clearly bearish. It will most likely take several months for the core features of the new reality to change much at all.

(click image to enlarge)

Low oil prices create both winners and losers on the international scene. First, the winners’ list.

Far and away the biggest winner from drastically lower prices is the world’s largest consumer and importer of oil: the United States. The last two years of high prices have spawned a sustained American consumer effort to get by with less oil via a mix of conservation and a shift to better-mileage vehicles. Whether this purchase pattern in automobiles lasts is not at issue. The point is that it has already happened: Many Americans have already shifted to more fuel-efficient vehicles. Just as the 1990s obsession with sport utility vehicles artificially boosted American gasoline demand so long as those automobiles were on the road, so the new fleet of hybrids and smart cars will push demand in the opposite direction for a sustained period.

Overall U.S. oil consumption has plummeted by nearly 9 percent from its peak in August 2007 to November 2008, according to the U.S. Department of Energy. Combining this with the drop in prices since July translates into U.S. energy savings of approximately US$1.95 billion at a price of US$50 a barrel and US$2.1 billion at a price of US$40 a barrel. And that is daily cost savings. In recessionary times, that cash will go a long way to building confidence and stanching the recession.

Next on the list are the major European importers of crude: Germany, Italy and Spain. As a rule, European economies are less energy-intensive than the United States, but by dint of fuel mix and lack of domestic production these three major states are forced to rely on substantial amounts of imported oil. We exclude the other major European economies from this list as they are either major oil producers themselves (the United Kingdom and the Netherlands) or their economies are extremely oil efficient (France, Belgium and Sweden). Don’t get us wrong — the EU states are all quite pleased that oil prices have dialed back. Nevertheless, in terms of relative gain, Germany, Italy and Spain are the real winners. And with Europe facing a recession much deeper and likely longer than that in the United States, the Europeans need every advant age they can get.

India, far removed from Europe culturally and geographically, sports a somewhat similar economic structure in that it boasts (or suffers from, based on your perspective) an industrializing base that is highly dependent on oil imports. Broadly, the Indians are in the same basket as Spain in that they are voracious energy consumers who have seen their demand skyrocket in recent years. Between the Nov. 26 Mumbai attack, upcoming federal elections and the energy price pain from earlier in the year, the government is desperate to pass on the cost savings to the population to shore up its support.

Then there are the East Asian states of South Korea, China and Japan (listed in descending order of how much each one benefits from the price drop). All import massive amounts of crude oil, but we put them at the end of the list of winners because of their financial systems. In East Asia — and particularly in China and Japan — money is not allocated on the basis of rate of return or profitability as it is in the West. Instead, the concern is maximizing employment. It does not matter much in East Asia if one’s business plan is sound; the government will provide cheap loans so long one employs hordes of people. One side effect of this strategy is that firms can get loans for anything, including raw materials they otherwise could not afford — such as oil at US$147 a barrel.

Therefore, high oil prices just do not affect East Asia as badly as they affect the West. Just as the East Asian financial system mutes the impact of high prices, the converse is true as well. In the West, energy consumers are not shielded from high prices, so lower prices immediately translate into more purchasing power, and thus more economic activity. Not so in East Asia, where the same financial shielding that blunts the impact of high prices lessens the benefits of low prices.

The order in which we listed the three Asian giants relates to how much progress they have made in reforming their financial practices. South Korea’s financial system is much closer to the Western model than the Asian model: South Korea hurts more as prices rise, and so will be more relieved as prices fall. China is in the middle in terms of financial practices, but it is also attempting to unwind its system of energy price-fixing as oil costs drop; due to subsidies being reduced, Chinese consumers actually may not be seeing much of a change in retail prices. Finally, Japan will benefit the least because its system is already highly efficient compared to the other two, so the price impact was less in the first place. One barrel of oil consumed in Japan generates approximately US$2,610 of Japanese gross domestic product (GDP), while the comparative figures for Korea and China are US$1,270 and US$1,130 respectively.

In short, the heavily industrialized Asians still benefit, but the impact isn’t as much as one might think at first glance. In fact, the biggest benefit to these states from cheaper energy is indirect — lower prices spur consumption in the West, and then the West purchases more Asian products.

And now, the losers.

Venezuela and Iran top this list by far. Both are led by politicians who have lavished vast amounts of oil income on their populations to secure their respective political positions. But that public approval has come at its own price in terms of economic dislocation (why diversify the economy if strong oil prices bring in loads of cash?), low employment (the energy sector may be capital-intensive, but it certainly is not labor-intensive), and high inflation (high government spending has led to massive consumption and spurred rampant import of foreign goods to satiate that demand).

Of the two states, Venezuela is certainly in the worse position. By some estimates, Venezuela requires oil prices in the vicinity of US$120 a barrel to maintain the social spending to which its population has become accustomed. Iran’s number may be only somewhat lower, but President Mahmoud Ahmadinejad is in the process of at least beginning to bow to economic reality. On Dec. 5, he announced massive cuts in subsidy outlays with the intent of reforging the budget based on a price of only US$30 a barrel.

It is an open question whether the Iranian government — and especially the increasingly unpopular Ahmadinejad — can survive such cuts (if they are indeed made), but at least there is a public realization of the depth of the crisis at the top level of government. In Venezuela, by contrast, the mitigation process has barely begun, and for political reasons it cannot truly be implemented until after a referendum in early 2009 on term limits that could allow Chavez to run for president indefinitely.

Next is Nigeria. In terms of seeing an increase in human misery, Nigeria should probably be at the top of the losers’ list. But the harsh reality is that Nigerians are used to corrupt government, inadequate infrastructure, spotty power supply and all-around poor conditions. Some of the perks of high energy prices undoubtedly will disappear, but none of those perks succeeded in changing Nigeria in the first place.

The real impact on Nigeria will be that the government will have drastically less money available to grease the political wheels that allow it to keep competing regional and personal interests in check. Those funds have been particularly crucial for funneling cash to the country’s oil-rich Niger Delta region, giving local bosses reason not to hire and/or arm militant groups like the Movement for the Emancipation of the Niger Delta to attack oil and natural gas sites. With Abuja having less cash, the oil regions will see a surge in extortion, kidnapping and oil bunkering (i.e., theft). We already have seen attacks ramp up against the country’s natural gas industry: Within the last few days, attacks against supply points have forced operators to take the Bonny Island liquefied natural gas export facility offline. And since Nigeria’s mil itants never really differentiate between the country’s various forms of energy export, oil disruptions are probably just around the corner.

Russia is also in the crosshairs, but not nearly to the same degree as Venezuela, Iran and Nigeria. Russia has four things going for it that the others lack. First, it exports massive amounts of natural gas and metals, giving it additional income streams. (Venezuela and Iran actually import natural gas and have no real alternative to oil income.) Second, Russia never spent its money on its population. Thus, Russians have not become used to massive government support, so there will be no sharp cuts in public spending that will be missed by the populace. Third, Russia has saved nearly every nickel it made in the past eight years, giving it cash reserves worth some US$750 billion. The financial crisis is hitting Russia hard, so at least US$200 billion of that buffer already has been spent, but Russia still remains in a far better position than m ost oil exporters. Fourth and last, the Russians can rely on Deputy Prime Minister and Finance Minister Alexei Kudrin to (somewhat forcefully) keep the books firmly in balance. At his insistence, the government is in the process of refabricating its three-year budget on the basis of oil prices of below US$35 a barrel, down from the original estimate of US$95.

At the end of the losers’ list we have two states that most people would not think of: Mexico and Canada. Both have other sources of economic activity. Canada is a modern service-based economy with a heavy presence of many commodity industries, while Mexico has become a major manufacturing hub. But both are major oil exporters, and have been leading suppliers to the American economy for decades. So both are exposed, but their concerns are more about unforeseen complications rather than the “simple” quantitative impact of lower prices.

Mexico has purchased derivatives contracts that, in essence, insure the price of all its oil exports for 2009. So should prices remain low, Mexico’s actual income will be unchanged. We only include Mexico on the list of losers, therefore, because it’s quite rare in geopolitics that such planning actually works out as planned. Hurricanes and strikes happen. (Mexico also faces the problem of insufficient funds, expertise and technology to counter rapidly declining output, something that will leave it with a lack of oil to sell in the first place — but that is an issue more for 2012 than 2009.)

As for Canada, most of the oil it produces comes from Alberta province, the seat of power of the ruling Conservative Party. Right now, the Canadian government is wobbling like a slowing top. Seeing the Conservatives’ power base take a massive economic hit due to oil prices is not the sort of complication the government needs right now. In the longer term, Alberta recently increased taxes on oil sands projects. Oil sands extraction is among the more capital-intensive and technologically challenging sorts of oil production currently possible. Combine the tax changes with the nature of the subindustry and the recent price drops and there is likely to be precious little investment interest in oil dur ing — at a minimum — 2009.

Most readers will take note of the countries we have chosen not to include on the list of vulnerable states. These include the bulk of the OPEC states — specifically Angola, Iraq, Kuwait, Saudi Arabia, the United Arab Emirates, Qatar and Libya. All of these states count oil as their only meaningful export (except the United Arab Emirates and Qatar, which also export natural gas), so why do we feel such countries are not in the danger zone?

For its part, Angola only became a major producer recently. Nearly all of Angolan oil output is from offshore projects controlled by foreigners — shutting in such production is a very tricky affair for a country that is utterly reliant on foreign technology to operate its only meaningful industry. But the primary reason Angola is not feeling the heat is that most of its income has not been spent but instead has been stashed away due to a lack of the necessary physical and personnel infrastructure needed to leverage the income.

Iraq is in a somewhat similar position as far as finances are concerned. While Iraq has been producing crude for decades, its current government is only a few years old, and its institutions simply cannot allocate the monies involved. Despite massive outlays by both Iraq and Angola, their respective governments simply lack the capacity to spend, and so have stored up cash accounts worth US$26 billion and US$54 billion respectively.

The rest of the Arab oil producers warrant a much simpler explanation: They’ve been fiscally conservative. While all have shared the wealth with their somewhat restive populations, none of them has repeated the mistakes of the 1970s, when they overspent on gaudy buildings and overcommitted themselves to expensive social programs. All have been saving vast amounts of cash, with the Saudis alone probably having more than US$1 trillion socked away. Tiny Kuwait officially has a wealth fund worth more than US$250 billion.

So while none of the Arab oil states are particularly thrilled with the direction — and in particular the speed — oil prices have gone, none of these governments faces a mortal danger at this time. What they are now missing is the ability to make a substantial impact on the world around them. At oil’s height the Gulf Arab oil producers were taking in US$2 billion a day in revenues — far more cash than they could ever hope to metabolize themselves. Bribes are powerful tools of foreign policy, and their income allowed them — particularly Saudi Arabia — to wield outsized influence in Iraq, Syria, Lebanon, and even in Beijing, London and Washington. So while none of these states faces a meltdown from falling prices, there are certainly some hangovers in store for them. It is jus t that they are more political than economic in nature, at least for now.

Windfall Profits Tax is A Stupid Democratic Party Idea

The question to ask relative to the graphic on the left is; so what? A windfall profits tax is a tax on profits that ensue from a sudden windfall gain to a particular company or industry. Imposition of such a tax is a linchpin of Obama's energy policy. Its also a stupid idea which is every bit as pandering to the electorate as McCain's almost equally stupid summer gas tax holiday.

Lets use an analogy that's easy to assimilate: Before the housing bubble burst, housing prices were on the rise at a rapid clip. Many homeowners who sold at the height of the bubble made sizable gains on the sale of their home basically because they sold at the right time in the market. Maybe you were one of them. Now what would you say if Obama was proposing to levy a special extra tax on those gains you realized? Hell No! In fact, you won't find anybody proposing to tax those gains. My point exactly. What Obama is proposing to do to the oil companies is no different. It's hard to see why oil companies shouldn't make a lot of money when their product is suddenly in short supply. They are vulnerable to weak profits and losses during times of glut. Back when gasoline was cheap, nobody was shedding tears because oil companies were making small or no profits.

Face it folks, its a pander. Moreover, it frankly doesn't have as much going for it as McCain's gas tax holiday. At least with the gas tax holiday, in theory, we save a few pennies at the pump. Obama's plan simply taxes the oil companies more heavily so the government can spend the money on alternative energy research that even assuming the government did that correctly, won't pay off for years. So as a practical matter, it means squat at the pump where you and I are getting mauled on a daily basis.

I'm all for energy policy change, but if we are going to do it, then lets do it right and dispense with the half measures. We need to end US dependence on oil which is an economic drain, a national security weakness and keeps our country locked into a fossil fuels based economy that is bottling up innovative technologies that could change everything. On the one hand, high prices are doing us a lot of damage. On the other, the pain is spurring new approaches, and thats not all bad. As the Motley Fool points out:

"..... back in the 1970s, Brazil relied on the rest of the world for 85% of its oil. The result? Debt ballooned, and rampant inflation became the norm for decades. But those high prices pushed the need for change, and change is exactly what Brazil got. Innovation and commitment to overcoming the oil burden pushed Brazil to energy independence today by way of sugar cane-based ethanol (which is, importantly, far different from the corn-based ethanol made in America.) The oil embargo of the 1970s also pushed Denmark, which was 99% dependent on imported oil, to become one of the world's leaders in alternative energy, such as windmill technology. The important thing to realize is that it's highly doubtful that any of this would have happened if higher prices hadn't spurred people to action."

If we want to fix the problem, we have to go long. Hydrogen and electric car technology is within reach. The US and Canada sit on top of the largest shale oil deposits in the world, larger than Iraq's biggest fields, we just have to figure out how to get it out. McCain makes the point that the Europeans are using nuclear technology and have been doing so for years, so whats our problem? And you know, call me a hippie if you want, but somebody explain to me why we have after several million years on the planet, not figured out how to milk the solar systems largest, most reliable and don't that beat all, FREE energy source, the sun.

I don't know, but seems to me we got an embarrasment of energy alternatives, but we are too damn lazy and short term in our thinking to make it happen. Meanwhile, we ship hundreds of billions of dollars daily to regimes that don't like us much for last century's energy source, the oil crack our country has to have. Obama's my boy, but this aspect of his energy policy is simply stupid.

The Geopolitics of $130 Oil

By George Friedman (Honorary Political Season Contributor)

Oil prices have risen dramatically over the past year. When they passed $100 a barrel, they hit new heights, expressed in dollars adjusted for inflation. As they passed $120 a barrel, they clearly began to have global impact. Recently, we have seen startling rises in the price of food, particularly grains. Apart from higher prices, there have been disruptions in the availability of food as governments limit food exports and as hoarding increases in anticipation of even higher prices.

Oil and food differ from other commodities in that they are indispensable for the functioning of society. Food obviously is the more immediately essential. Food shortages can trigger social and political instability with startling swiftness. It does not take long to starve to death. Oil has a less-immediate — but perhaps broader — impact. Everything, including growing and marketing food, depends on energy; and oil is the world’s primary source of energy, particularly in transportation. Oil and grains — where the shortages hit hardest — are not merely strategic commodities. They are geopolitical commodities. All nations require them, and a shift in the price or availability of either triggers shifts in relationships within and among nations.

It is not altogether clear to us why oil and grains have behaved as they have. The question for us is what impact this generalized rise in commodity prices — particularly energy and food — will have on the international system. We understand that it is possible that the price of both will plunge. There is certainly a speculative element in both. Nevertheless, based on the realities of supply conditions, we do not expect the price of either to fall to levels that existed in 2003. We will proceed in this analysis on the assumption that these prices will fluctuate, but that they will remain dramatically higher than prices were from the 1980s to the mid-2000s.

If that assumption is true and we continue to see elevated commodity prices, perhaps rising substantially higher than they are now, then it seems to us that we have entered a new geopolitical era. Since the end of World War II, we have lived in three geopolitical regimes, broadly understood:

• The Cold War between the United States and the Soviet Union, in which the focus was on the military balance between those two countries, particularly on the nuclear balance. During this period, all countries, in some way or another, defined their behavior in terms of the U.S.-Soviet competition.
• The period from the fall of the Berlin Wall until 9/11, when the primary focus of the world was on economic development. This was the period in which former communist countries redefined themselves, East and Southeast Asian economies surged and collapsed, and China grew dramatically. It was a period in which politico-military power was secondary and economic power primary.
• The period from 9/11 until today that has been defined in terms of the increasing complexity of the U.S.-jihadist war — a reality that supplanted the second phase and redefined the international system dramatically.

With the U.S.-jihadist war in either a stalemate or a long-term evolution, its impact on the international system is diminishing. First, it has lost its dynamism. The conflict is no longer drawing other countries into it. Second, it is becoming an endemic reality rather than an urgent crisis. The international system has accommodated itself to the conflict, and its claims on that system are lessening.

The surge in commodity prices — particularly oil — has superseded the U.S.-jihadist war, much as the war superseded the period in which economic issues dominated the global system. This does not mean that the U.S.-jihadist war will not continue to rage, any more than 9/11 abolished economic issues. Rather, it means that a new dynamic has inserted itself into the international system and is in the process of transforming it.

It is a cliche that money and power are linked. It is nevertheless true. Economic power creates political and military power, just as political and military power can create economic power. The rise in the price of oil is triggering shifts in economic power that are in turn creating changes in the international order. This was not apparent until now because of three reasons. First, oil prices had not risen to the level where they had geopolitical impact. The system was ignoring higher prices. Second, they had not been joined in crisis condition by grain prices. Third, the permanence of higher prices had not been clear. When $70-a-barrel oil seemed impermanent, and likely to fall below $50, oil was viewed very differently than it was at $130, where a decline to $100 would be dramatic and a fall to $70 beyond the calculation of most. As oil passed $120 a barrel, the international system, in our view, started to reshape itself in what will be a long-term process.

Obviously, the winners in this game are those who export oil, and the losers are those who import it. The victory is not only economic but political as well. The ability to control where exports go and where they don’t go transforms into political power. The ability to export in a seller’s market not only increases wealth but also increases the ability to coerce, if that is desired.

The game is somewhat more complex than this. The real winners are countries that can export and generate cash in excess of what they need domestically. So countries such as Venezuela, Indonesia and Nigeria might benefit from higher prices, but they absorb all the wealth that is transferred to them. Countries such as Saudi Arabia do not need to use so much of their wealth for domestic needs. They control huge and increasing pools of cash that they can use for everything from achieving domestic political stability to influencing regional governments and the global economic system. Indeed, the entire Arabian Peninsula is in this position.

The big losers are countries that not only have to import oil but also are heavily industrialized relative to their economy. Countries in which service makes up a larger sector than manufacturing obviously use less oil for critical economic functions than do countries that are heavily manufacturing-oriented. Certainly, consumers in countries such as the United States are hurt by rising prices. And these countries’ economies might slow. But higher oil prices simply do not have the same impact that they do on countries that both are primarily manufacturing-oriented and have a consumer base driving cars.

East Asia has been most affected by the combination of sustained high oil prices and disruptions in the food supply. Japan, which imports all of its oil and remains heavily industrialized (along with South Korea), is obviously affected. But the most immediately affected is China, where shortages of diesel fuel have been reported. China’s miracle — rapid industrialization — has now met its Achilles’ heel: high energy prices.

China is facing higher energy prices at a time when the U.S. economy is weak and the ability to raise prices is limited. As oil prices increase costs, the Chinese continue to export and, with some exceptions, are holding prices. The reason is simple. The Chinese are aware that slowing exports could cause some businesses to fail. That would lead to unemployment, which in turn will lead to instability. The Chinese have their hands full between natural disasters, Tibet, terrorism and the Olympics. They do not need a wave of business failures.

Therefore, they are continuing to cap the domestic price of gasoline. This has caused tension between the government and Chinese oil companies, which have refused to distribute at capped prices. Behind this power struggle is this reality: The Chinese government can afford to subsidize oil prices to maintain social stability, but given the need to export, they are effectively squeezing profits out of exports. Between subsidies and no-profit exports, China’s reserves could shrink with remarkable speed, leaving their financial system — already overloaded with nonperforming loans — vulnerable. If they take the cap off, they face potential domestic unrest.

The Chinese dilemma is present throughout Asia. But just as Asia is the big loser because of long-term high oil prices coupled with food disruptions, Russia is the big winner. Russia is an exporter of natural gas and oil. It also could be a massive exporter of grains if prices were attractive enough and if it had the infrastructure (crop failures in Russia are a thing of the past). Russia has been very careful, under Vladimir Putin, not to assume that energy prices will remain high and has taken advantage of high prices to accumulate substantial foreign currency reserves. That puts them in a doubly-strong position. Economically, they are becoming major players in global acquisitions. Politically, countries that have become dependent on Russian energy exports — and this includes a good part of Europe — are vulnerable, precisely because the Russians are in a surplus-cash position. They could tweak energy availability, hurting the Europeans badly, if they chose. T hey will not need to. The Europeans, aware of what could happen, will tread lightly in order to ensure that it doesn’t happen.

As we have already said, the biggest winners are the countries of the Arabian Peninsula. Although somewhat strained, these countries never really suffered during the period of low oil prices. They have now more than rebalanced their financial system and are making the most of it. This is a time when they absolutely do not want anything disrupting the flow of oil from their region. Closing the Strait of Hormuz, for example, would be disastrous to them. We therefore see the Saudis, in particular, taking steps to stabilize the region. This includes supporting Israeli-Syrian peace talks, using influence with Sunnis in Iraq to confront al Qaeda, making certain that Shiites in Saudi Arabia profit from the boom. (Other Gulf countries are doing the same with their Shiites. This is designed to remove one of Iran’s levers in the region: a rising of Shiites in the Arabian Peninsula.) In addition, the Saudis are using their economic power to re-establish the relationship they ha d with the United States before 9/11. With the financial institutions in the United States in disarray, the Arabian Peninsula can be very helpful.

China is in an increasingly insular and defensive position. The tension is palpable, particularly in Central Asia, which Russia has traditionally dominated and where China is becoming increasingly active in making energy investments. The Russians are becoming more assertive, using their economic position to improve their geopolitical position in the region. The Saudis are using their money to try to stabilize the region. With oil above $120 a barrel, the last thing they need is a war disrupting their ability to sell. They do not want to see the Iranians mining the Strait of Hormuz or the Americans trying to blockade Iran.

The Iranians themselves are facing problems. Despite being the world’s fifth-largest oil exporter, Iran also is the world’s second-largest gasoline importer, taking in roughly 40 percent of its annual demand. Because of the type of oil they have, and because they have neglected their oil industry over the last 30 years, their ability to participate in the bonanza is severely limited. It is obvious that there is now internal political tension between the president and the religious leadership over the status of the economy. Put differently, Iranians are asking how they got into this situation.

Suddenly, the regional dynamics have changed. The Saudi royal family is secure against any threats. They can buy peace on the Peninsula. The high price of oil makes even Iraqis think that it might be time to pump more oil rather than fight. Certainly the Iranians, Saudis and Kuwaitis are thinking of ways of getting into the action, and all have the means and geography to benefit from an Iraqi oil renaissance. The war in Iraq did not begin over oil — a point we have made many times — but it might well be brought under control because of oil.

For the United States, the situation is largely a push. The United States is an oil importer, but its relative vulnerability to high energy prices is nothing like it was in 1973, during the Arab oil embargo. De-industrialization has clearly had its upside. At the same time, the United States is a food exporter, along with Canada, Australia, Argentina and others. Higher grain prices help the United States. The shifts will not change the status of the United States, but they might create a new dynamic in the Gulf region that could change the framework of the Iraqi war.

This is far from an exhaustive examination of the global shifts caused by rising oil and grain prices. Our point is this: High oil prices can increase as well as decrease stability. In Iraq — but not in Afghanistan — the war has already been regionally overshadowed by high oil prices. Oil-exporting countries are in a moneymaking mode, and even the Iranians are trying to figure out how to get into the action; it’s hard to see how they can without the participation of the Western oil majors — and this requires burying the hatchet with the United States. Groups such as al Qaeda and Hezbollah are decidedly secondary to these considerations.

We are very early in this process, and these are just our opening thoughts. But in our view, a wire has been tripped, and the world is refocusing on high commodity prices. As always in geopolitics, issues from the last generation linger, but they are no longer the focus. Last week there was talk of Strategic Arms Reduction Treaty (START) talks between the United States and Russia — a fossil from the Cold War. These things never go away. But history moves on. It seems to us that history is moving.

China and the Arabian Peninsula as Market Stabilizers

By George Friedman (honorary Political Season contributor)

The single most interesting thing about today's global economy is what has not occurred. In 1979, oil prices soared to slightly more than $100 a barrel in current dollars, and they are approaching that historic high again. Meanwhile, the subprime meltdown continues to play out. Many financial institutions have been hurt, many individual lives have been shattered and many Wall Street operators once considered brilliant have been declared dunderheads. Despite all the predictions that the current situation is just the tip of the iceberg, however, the crisis is progressing in a fairly orderly fashion. Distinguish here between financial institutions, financial markets and the economy. People in the financial world tend to confuse the three. Some financial institutions are being hurt badly. Those experiencing the pain mistakenly think their suffering reflects the condition of the financial markets and economy. But the financial markets are managing, as is the economy.

What we are seeing is the convergence of two massive forces. Oil prices, along with primary commodity prices in general, have soared. Also, one of the periodic financial bubbles -- the subprime mortgage market -- has burst. Either of these alone should have created global havoc. Neither has. The stock market has not plummeted. The Standard & Poor's 500 fell from a high of about 1,565 in mid-October to a low of 1,400 on Oct. 19. Since then, it has rebounded as high as 1,550. Given the media rhetoric and the heads rolling in the financial sector, we would expect to see devastating numbers. And yet, we are not.

Nor are the numbers devastating in the bond markets. By definition, a liquidity crisis occurs when the money supply is too tight and demand is too great. In other words, a liquidity crisis would be reflected in high interest rates. That hasn't happened. In fact, both short-term and, particularly, long-term interest rates have trended downward over the past weeks. It might be said that interest rates are low, but that lenders won't lend. If so, that is sectoral and short-term at most. Low interest rates and no liquidity is an oxymoron.

This is not the result of actions at the Federal Reserve. The Fed can influence short-term rates, but the longer the yield curve, the longer the payoff date on a loan or bond and the less impact the Fed has. Long-term rates reflect the current availability of money and expectations on interest rates in the future.

In the U.S. stock market -- and world markets, for that matter -- we have seen nothing like the devastation prophesied. As we have said in the past, the subprime crisis compared with the savings and loan crisis, for example, is by itself small potatoes. Sure, those financial houses that stocked up on the securitized mortgage debt are going to be hurt, but that does not translate into a geopolitical event, or even into a recession. Many people are arguing that we are only seeing the tip of the iceberg, and that defaults in other categories of the mortgage market coupled with declining housing markets will set off a devastating chain reaction.

That may well be the case, though something weird is going on here. Given the broad belief that the subprime crisis is only the beginning of a general financial crisis, and that the economy will go into recession, we would have expected major market declines by now. Markets discount in anticipation of events, not after events have happened. Historically, market declines occur about six months before recessions begin. So far, however, the perceived liquidity crisis has not been reflected in higher long-term interest rates, and the perceived recession has not been reflected in a significant decline in the global equity markets.

When we add in surging oil and commodity prices, we would have expected all hell to break loose in these markets. Certainly, the consequences of high commodity prices during the 1970s helped drive up interest rates as money was transferred to Third World countries that were selling commodities. As a result, the cost of money for modernizing aging industrial plants in the United States surged into double digits, while equity markets were unable to serve capital needs and remained flat.

So what is going on?

Part of the answer might well be this: For the past five years or so, China has been throwing around huge amounts of cash. The Chinese made big, big money selling overseas -- more than even the growing Chinese economy could metabolize. That led to massive dollar reserves in China and the need for the Chinese to invest outside their own financial markets. Given that the United States is China's primary consumer and the only economy large and stable enough to absorb its reserves, the Chinese -- state and nonstate entities alike -- regard the U.S. markets as safe-havens for their investments. That is one of the things that have kept interest rates relatively low and the equity markets moving. This process of Asian money flowing into U.S. markets goes back to the early 1980s.

Another part of the answer might lie in the self-stabilizing feature of oil prices, the rise of which should be devastating to U.S. markets at first glance. The size of the price surge and the stability of demand have created dollar reserves in oil-exporting countries far in excess of anything that can be absorbed locally. The United Arab Emirates, for example, has made so much money, particularly in 2007, that it has to invest in overseas markets.

In some sense, it doesn't matter where the money goes. Money, like oil, is fungible, which means that if all the petrodollars went into Europe then other money would flow into the United States as European interest rates fell and European stocks rose. But there are always short-term factors to consider. The Persian Gulf oil producers and the Chinese have one thing in common -- they are linked to the dollar. As the dollar declines, assets in other countries become more expensive, particularly if you regard the dollar's fall as ultimately reversible. Dollars invested in dollar-denominated vehicles make sense. Therefore, we are seeing two massive inflows of dollars to the United States -- one from China and one from the energy industry. China's dollar reserves are derived from sales to the United States, so it is stuck in the dollar zone. Plus, the Chinese have pegged the yuan to the dollar. The energy industry, also part of the dollar zone, needs to find a home for its money -- and the largest, most liquid dollar-denominated market in the world is the United States.

The United States has created an odd dollar zone drawing in China and the Persian Gulf. (Other energy producers such as Russia, Nigeria and Venezuela have no problem using their dollars internally.) Unhinging China from the dollar is impossible; it sells in dollars to the United States, a linkage that gives it a stable platform, even if it pays relatively more for oil. Additionally, the Arabian Peninsula sells oil in dollars, and trying to convert those contracts to euros would be mind-bogglingly difficult. Existing contracts and new contracts managed in multiple currencies -- both spot and forward managed -- would have to be renegotiated. Any business working in multiple currencies faces a challenge, and the bigger the business, the bigger the challenge. The Arabian Peninsula accordingly will not be able to hedge currencies and manage the contracts just by flipping a switch.

This provides an explanation for the resiliency of U.S. markets. Every time the news on the subprime situation sounds so horrendous that it seems the U.S. markets will crash, the opposite occurs. In fact, markets in the United States rose through the early days, then sold off and now have rallied again. Where is the money coming from?

We would argue that the money is coming from the dollar bloc and its huge free cash flow from China, and at the moment, the Arabian Peninsula in particular. This influx usually happens anonymously through ordinary market actions, though occasionally it becomes apparent through large, single transactions that are quite open. Last week, for example, Dubai invested $7 billion in Citigroup, helping to clean up the company's balance sheet and, not incidentally, letting it be known that dollars being accumulated in the Persian Gulf will be used to stabilize U.S. markets.

This is not an act of charity. Dubai and the rest of the Arabian Peninsula, as well as China, are holding huge dollar reserves, and the last thing they want to do is sell those dollars in sufficient quantity to drive the dollar's price even lower. Nor do they want to see a financial crisis in the U.S. markets. Both the Chinese and the Arabs have far too much to lose to want such an outcome. So, in an infinite number of open market transactions, as well as occasionally public investments, they are moving to support the U.S. markets, albeit for their own reasons.

It is the only explanation for what we are seeing. The markets should be selling off like crazy, given the financial problems. They are not. They keep bouncing back, no matter how hard they are driven down. That money is not coming from the financial institutions and hedge funds that got ripped on mortgages. But it is coming from somewhere. We think that somewhere is the land of $90-per-barrel crude and really cheap toys.

Many people will see this as a tilt in global power. When others must invest in the United States, however, they are not the ones with the power; the United States is. To us, it looks far more like the Chinese and Arabs are trapped in a financial system that leaves them few options but to recycle their dollars into the United States. They wind up holding dollars -- or currencies linked to dollars -- and then can speculate by leaving, or they can play it safe by staying. In our view, these two sources of cash are the reason global markets are stable.

Energy prices might fall (indeed, all commodities are inherently cyclic, and oil is no exception), and the amount of free cash flow in the Arabian Peninsula might drop, but there still will be surplus dollars in China as long as it is an export-based economy. Put another way, the international system is producing aggregate return on capital distributed in peculiar ways. Given the size of the U.S. economy and the dynamics of the dollar, much of that money will flow back into the United States. The United States can have its financial crisis. Global forces appear to be stabilizing it.

The Chinese and the Arabs are not in the U.S. markets because they like the United States. They don't. They are locked in. Regardless of the rumors of major shifts, it is hard to see how shifts could occur. It is the irony of the moment that China and the Arabian Peninsula, neither of them particularly fond of the United States, are trapped into stabilizing the United States. And, so far, they are doing a fine job.