SPECIAL REPORT

January 23, 2009

Politics, geopolitics and financial

flows in a ‘low’ oil price environment
Ed Morse
Managing Director
Chief Economist
+1 212 651 3196
emorse@lcmcommodities.com
Edward Kott
Senior Associate
+1 212 651 3176
ekott@lcmcommodities.com
DURING THE PAST FIVE YEARS THE INTERNATIONAL OIL SECTOR
B E C A M E a vital laboratory for those of us intrigued by the interaction of domestic policies
and international politics, of oil and money, and of the uses of oil as an instrument of foreign
policy in the service of other political goals by governments of resource rich countries. Then,
as now, there were the usual debates between those in the analytical community whose views
are well-entrenched and those who believe that history doesn’t exactly repeat itself and are
eager to find something new. The former camp includes what has been until recently a
growing consensus that peak oil is here as well as economists whose views of the market are
based on static theory. The latter camp includes those who have seen in the unprecedented
rise of financial flows – speculative as well as passive, technically- as well as fundamentally-
based – something fresh, providing new interactions between Saudi Arabia and OPEC on the
one hand and “systemic” markets on the other; it also includes those who were not surprised
by oil prices, which have always reflected a cyclical industry, falling precipitously last year.
Commodity markets in general and oil markets in particular have enjoyed a history of sudden
turning points. Some of these, as in 1971-72, when the elements of a dramatic and
unprecedented rise in prices were put in place, have foreshadowed a long-term period during
which oil importers feared the consequences of supply disruptions and oil-rich exporters
obsessed over finding ways to prolong the sector’s expansionary phase. Other periods, as in
1982-85, saw importers grow complacent about the operations of the energy market and
exporters find ways to act in concert to shift the burden of adjustment to lower prices onto
the markets on whose growth the producers depended.
It is premature to conclude that the sharp fall in prices that began in July 2008 presages a
new basic turning point in oil markets. But it’s safe to project that markets will remain softer
for the next two to three years than they were in the last five. If this is the case, what can we
conclude will likely characterize the interplay of domestic politics, international geopolitics
and financial flows in the oil sector in the near to medium term?

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With lower prices, the power
of the oil weapon is waning
rapidly
Within the OECD oil has
been relinquished as an
instrument of policy
For some oil producers the
‘oil weapon’ is ever present
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A more feckless oil weapon
THE LAST FIVE YEARS SAW THE REBIRTH OF THE USE OF OIL AS A
C R I T I C A L I N S T R U M E N T of foreign policy by key resource countries – Iran, Russia
and Venezuela in particular. The underlying geopolitics of the oil market is defined by the
world’s dependence on oil as an energy source, particularly but not only in the transportation
sector, and by the concentration of oil resources – both assets and flows—in a handful of
countries. As energy prices were rising, these countries rapidly earned increased respect
from other governments and investors, which propelled them to rely increasingly on oil and
natural gas as instruments of foreign policy. The degree to which the Chavez example
reverberated in Latin America is one reflection of this, just as Moscow’s assertive attitude
has brought more heavy-handed Russian diplomacy to neighboring states, from Ukraine
through Transcaucasia to Central Asia, than at any time since the collapse of the USSR.
With oil and natural gas prices having collapsed, the power of their weapons has been
waning rapidly, turning creditor into debtor nations and depriving them of the revenues
required to fulfill their international goals. This too is problematical internationally for this
reduction in their power has been swift and the governments involved find it difficult to
believe that the authority they earned in a period of high oil prices has withered. Two
dangers loom on the horizon, each with global consequences. First, lower revenues are
creating domestic political problems, as the populations of key energy-producing countries
have grown accustomed to much higher per capita incomes as energy prices soared.
Financial problems are likely to emerge as companies and some governments inevitably
default on their international obligations. Second, with their power weakened, other countries
may be tempted to try to weaken the resource players further, unleashing unpredictable
forces.
In thinking about how the oil instrument or weapon might evolve within this environment
during the coming years, it is useful to reexamine the context of oil’s use as an instrument of
foreign policy, especially if the oil market is about to undergo a sustained period of weak
demand and low prices. This context is related to the division of the world as a whole into
three broadly different sets of countries.
F I R S T , T H E US, C A N A D A , T H E C O U N T R I E S O F W E S T E R N E U R O P E
A N D OE C D A S I A have basically relinquished the use of oil as an instrument of policy in
their relationships with one another. Although aspects of their own xenophobic pasts come to
light from time to time, by and large these countries have given up impeding flows of energy
or flows of capital into energy in the relations with one another. They have dismantled the
state – at least so far – when it comes to energy regulations, and both the flow of goods and
the flow of capital among them is guaranteed and unimpeded. When it comes to relations
with the outside world – with OPEC countries, Russia or other emerging markets – their
positions are more nuanced and frequently embody the direct and unabashed use of oil as an
instrument of policy, as had been the case of US and European relations with Libya until
recently and with Iran over most of the past decade and a half.
For a second group of countries, for whom earnings from oil and gas are critical sources of
government revenues and critical factors in their economies, the sector traditionally remains
a core instrument of foreign policy. What differentiates how oil or gas may be used as a
weapon is the state of hydrocarbon markets and of oil and gas prices. In a relatively benign
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 SPECIAL REPORT

For the ‘BRICs’ the oil
weapon is a frequent
temptation
environment, resource rich countries are as dependent on their markets as their markets are
on them, and from time to time even more so. This means that they do not have freedom to
take advantage of their customers in a zero-sum manner, in which one’s gain comes at
another’s loss. Rather the world is more ambiguous and at best a seller or a buyer must think
in terms of relative gains or losses – both gain together but one more than the other; or both
lose together, but one more than the other. In tight markets, however, the naked,
unadulterated oil weapon comes into its own. It can take on the brutal face of Russian gas
diplomacy – withholding supply to blackmail others, either for money or for political
reasons. Or it can take on the more subtle face of Iranian and Venezuelan diplomacy, where
oil revenue is critical because of the geopolitical uses to which that revenue is put.
The third group of countries includes much of the emerging market world. Among the so-
called BRICs, the darlings of emerging market investments in the middle part of this decade,
Russia clearly falls in the second category of countries, but Brazil, India and China, like most
emerging market governments, are in a position of ambiguous status. India and China are oil
importers and while state firms play a large role in the energy sector, so do market
mechanisms. Indeed in their relations with other countries, especially with the OECD
countries, Brazil, India and China have clearly opted far more for market solutions that limit
the role of energy as an instrument of policy. It is likely the case that if low oil prices persist
for several years, these emerging market countries will find that subsidizing energy
objectives will become increasingly too expensive and will move increasingly into the “first
world” camp. The implication is that Chinese policy will increasingly look like India’s – the
state will decreasingly favor national flag companies and nationally-owned companies will
focus on their commercial objectives and shun circumstances in which governments use
them for larger non-energy foreign policy purposes. And Brazil, as a major emerging long-
term exporter will likely evolve to look far more like the UK or even Norway, with its
national champion company forced to confront competition in its home market to keep it
honest and competitive.

Figure 1. Real per capita net oil export revenue of Figure 2. Nominal OPEC oil export revenues
selected OPEC countries (2000$)

$20,000 OPEC billion usd Libya

$18,000 UAE 1,200 Venezuela
$16,000 Saudi Arabia Nigeria
1,000 Kuw ait
$14,000 Venezuela
Iran
$12,000 Iran 800
UAE
$10,000 Nigeria Saudi Arabia
600
$8,000 Other OPEC

$6,000 400
$4,000
200
$2,000
$0 0
1994 1996 1998 2000 2002 2004 2006 2008 1996 1998 2000 2002 2004 2006 2008

Source: EIA. Source: EIA.

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Russia has lost the power of
the oil weapon, but still
thinks it commands its
former authority
Russia has aggressively
used oil and gas as an
instrument of policy in
recent years
Venezuela may have to
confront its new weakness
sooner
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THE ABRUPT DECLINE IN OIL PRICES IS HAVING AN IMMEDIATE AND
C O R R O S I V E I M P A C T on resource producers, especially those highly dependent on oil
revenues both for uses at home and internationally. For Russia, revenues from oil and gas
resources, whether from domestic sales and taxes or foreign sales and export taxes are
critical to the legitimacy of the state and its hopes of pursuing assertive policies abroad. The
former superpower has, especially during the Putin years, which have coincided with higher
and higher oil prices, grown critically dependent on its oil and gas revenues and on the oil
and gas weapon for exerting influence abroad. While pegging a government budget’s
breakeven oil or natural gas price is difficult, it is clear that hopes and plans that emerged in
a world of $140 oil are challenged at $90 and are pretty close to impossible to meet at $40.
And at $40 the country needs to confront fundamental choices between capital expenditures
at home and spending at home and abroad.
Recent years abound with examples of the use of oil and natural gas as instruments of foreign
policy by Russia. These include, especially, efforts to rein in the near abroad former USSR
independent states of south central Asia, Ukraine and the Balkans, efforts that use pipeline
connections through Russian-controlled territory that provide access to third-party markets in
the Mediterranean, Northern Europe and East Asia. But since August, the problems imposed
on Russia by lower oil and gas prices abound. Note:
• The difficulty in using the power of denial in negotiations over supply. This past
winter’s cutoff of natural gas to and through Ukraine to European markets is
particularly instructive. Russia’s bargaining position has, from the beginning, been
undermined by two factors. On the one hand, West European governments have
grown wary of Russian “guaranteed” supplies to the point of frightening populations
enough to provide bite to EU policy proposals limiting vulnerability to Russian
supplies. On the other hand, Russia’s critical need for revenue from natural gas
exports has from the outset limited the credibility of Russia’s denial of supply.
• While prices were rising, Russian firms used their unfettered access to Western
credit markets to borrow for capital and other programs with no strings attached.
This has been particularly the case for Gazprom, which has borrowed many billions
of dollars in Western markets since 2004 – its debt swelled 41% in 2007 alone –
without requirements to reinvest in new supplies, indeed without much of anything
in the way of strings or conditionality. As a result, Gazprom used the capital to buy
assets abroad within the very countries originating the credit and without any
monitoring of the many uses to which the capital might have been put. With cash
flow now reduced to a fraction of earlier expectations, and international credit
having vanished, Gazprom and other Russian firms’ last credit resort is the state,
whose own revenue base has been slashed and whose rapidly-depreciating currency
is making debt repayment even more difficult.
Venezuela, already overspending when oil was at $147 per barrel, is confronting
extraordinarily harsh realities, which we will discuss below, impacting the legitimacy of the
Chavez regime and causing it to face unhappy choices. Other Andean oil and gas producers
are confronting similar realities directly affecting the ability of governments in Argentina,
Bolivia, Ecuador, Peru and to some extent Colombia, to meet commitments at home, let
alone abroad. For Iran, while the pain might be more muted than in Venezuela, the
government budget is increasingly challenged and if prices remain at current levels for long –
Page - 4

In today’s softer markets
importing countries may
again find oil sanctions
attractive
Resource nationalism will,
however, be a “sticky”
phenomenon
Resource nationalism is
basically a reflection of
tightening market
conditions
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or even rise toward $70 – the government will be unable to support the array of international
activities that it has engaged in recent years. In particular, it will be strained to continue to
support various groups throughout the Middle East in pursuit of the government’s
international policies.
The flip side of the erosion of the use of oil or natural gas as an instrument of foreign policy
is the potentially wider attraction to its use by oil importing countries. From a global
perspective, the most widespread use of oil as an instrument of policy by an oil importer has
been the United States, through its perennial political attraction for sanctions against oil
producers to deprive them of revenue. Newly-elected President Obama is himself on the
record as favoring a more entrenched gasoline embargo of Iran, for example. It remains to be
seen how his Administration’s attitude toward what might be perceived as renegade oil
producers will evolve. But the history of US administrations using oil sanctions, especially in
periods of low oil prices, suggests that regardless of arguments that might be made that these
sanctions are in the long run likely to be ineffective and counterproductive, the new
Administration is likely to be tempted to follow the path of its predecessors.
The taming of resource nationalism
HUGO CHAVEZ CAME TO POWER IN VENEZUELA IN AN ELECTORAL
L A N D S L I D E at the lowest point that oil prices reached in 1998, ushering in a decade of
increased resource nationalism, with its many faces. The Venezuelan case was particularly
poignant insofar as this phenomenon is normally associated with the increased role of the
state in the management of national resources and of the energy sector as part of the
enhancement of state power. In Venezuela, rather ironically, Chavez found in the state
company PDVSA less a source of power than an impediment to government control.
Dismantling the state firm turned out to be a pre-requisite to the new resource nationalism.
That’s because in many ways the independent state firm had latched onto the logic of
globalization and became the supporter not only of the pursuit of commercial rather than
political objectives, but in the process the main supporter of two trends that epitomized
globalization: investment abroad, especially in the main markets to which PDVSA sold crude
oil and mostly in the form of refining assets, and foreign investment at home, bringing in
additional capital to exploit marginal fields on the one hand and fields where their local firm
had lacked technical expertise.
But another aspect of the Chavez revolution resonated internationally, a fundamental change
that manifested as oil markets tightened after 2003. One of the conditions of tightening
markets is that they facilitate a process whereby governments – the main holders of acreage
being made available to investors to exploit resources – increase the cost of acreage
acquisition and resource exploitation as the balance of power weighs more heavily on their
side than on that of companies. In short, those with capital, technology and human capacities
to exploit resources must cater in tight markets to those (the governments) with acreage and
seeking capital technology and management skills. Taxes go up as the market for exploration
rights tightens and the price and fiscal take associated with exploration rights also increases.
During the past five years as the world underwent an exploration boom, the costs of
exploration and production – finding and development costs – have increased at a
phenomenal rate, by 350% or more between 2004 and 2008. Part of the increase was in the
Page - 5

In today’s softer market
companies with capital to
spend are gaining
bargaining clout
The sharp fall in prices
appears to be accelerating
the decline of resource
nationalism
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form of taxes or rents from exploration and production imposed by governments. One of the
most interesting features of this element of costs is that they are sticky even as competitive
conditions emerge, For example, during the past nine months, the costs of tubular steel, day
rights for shallow water rigs and vertical land rigs, the price of engineering services and an
array of other costs have fallen. The cost deflation partly reflects overcapacities that have
recently emerged, as in steel costs or in shallow water exploration, where rig availability has
increased due to recent capital expenditure programs. Yet measures of exploration and
development costs have not experienced the same 30-50% reduction seen in these core costs.
That’s because critical contracts are longer term in nature; deepwater rig day rates are set in
term contracts lasting 5 or 10 years and rig owners holding of these contracts are reluctant to
renegotiate their terms.
One of the features in the landscape of the upstream sector today is a bargaining ritual
unfolding between companies with capital to expend and contractors whose services are
required for exploration and development programs. The same ritual dance is unfolding in
the relationship between governments and their issuance of exploration licenses and firms in
their quest. Undoubtedly, in the short run all of the costs are sticky. Just as drilling
contractors are reluctant reduce rates, so too are governments reluctant to start competing
with one another to attract capital to invest in exploration and production activities.
Some analysts have argued that the government tax regimes in place are so sticky that there
is little hope that governments will change policy rapidly or any time soon to attract capital
for investment in natural resources. One major international oil consultancy has recently
concluded after conducting a rapidly put together survey that a reversal in resource
nationalism is unlikely to take place in the near term, concluding that government policy in
this area takes a long time to reverse. This conclusion might well be overly hasty. It is based
on conditions of the 1970s which are far different from those of today in critical respects.
The new turn toward resource nationalism, for example, follows a period in which it was
neither fashionable nor cost effective, as opposed to what unfolded in the 1970s when most
of the energy resources of the world were nationalized. The superficial survey also ignores
the rather rapidly responsive fiscal changes that took place in the UK, Norway and Canada,
where governments, having tightened terms for foreign investors, loosened them rapidly and
considerably when confronted with highly competitive conditions for attracting capital. It
just might be the case that the rapid collapse in oil prices over the past nine months might
also be accelerated by reversal of resource nationalism.
In some resource rich countries, the need for capital to boost production in order to boost
revenue is becoming critical. Over the past few weeks one of the governments leading the
movement to attract capital is the same one that led the resource nationalism charge in a
rising price environment, namely Caracas. Hugo Chavez’s new attempt to attract capital for
the Orinoco belt this summer may well not attract the capital required because of low prices
and because of the recent history in dealing with foreign ownership and the well-know
counter actions of Exxon especially and also of ConocoPhillips to those moves. But other
companies have remained in Venezuela and are bullish on their ability to exploit heavy oil
resources. Penetrating their bargaining postures at this stage is a bit premature. A prolonged
period of low prices brings with it the potential for significantly lower costs, both for
development and for operations.
Page - 6
 SPECIAL REPORT

Venezuela is not alone in confronting the dilemma that without external capital, technology
and project management skills, its resource base might erode too rapidly. Among major oil
producing countries, Russia, Iran and Iraq are in a similar position and even Brazil might
find that spreading the risks of exploration and development with foreign capital might be
highly attractive in a lower price environment. In Russia, production in 2008 was already
lower than in 2007 and the consensus is for a slide of 5% in the production base this year.
Both Gazprom in the natural gas sector and the companies seeking to exploit resource-rich
offshore waters increasingly recognize that it cannot develop the resource potential on their
own. It seems far more likely to expect a more rapid relaxation of terms in these major
resource countries than the skeptics now expect. And if Caracas and Moscow move in this
direction, it is likely to Baghdad, Brasilia, La Paz, Quito and Tehran will not be far behind.

Saudi Arabia and surplus capacities

The return of surplus
capacities appears likely to
last several years capping
prices…
…as a mirror reflection of
how lower capacities
accelerated the price rise
As in all tight markets, governments in consumer or importing countries have been obsessed
by fear of supply disruptions in the oil sector during the past five years. In recent years,
similar fears have entered the West European political landscape when it comes to disruption
of natural gas supplies from Russia. “Fear” has also, as always, been twinned with “greed”
on the part of exporters, creating an interplay between the two in a dance that become quite
complex.
There is little doubt that the decline in surplus oil production capacity to virtually zero in the
middle of this decade jolted markets. The lost cushion of surplus capacity, which had once
seemed a permanent fixture of oil markets before the price collapse of 1985, surprised all
market participants, not the least of which was Saudi Arabia, whose ability to supply markets

Figure 3. OPEC crude production and spare capacity (1973-2009)

kb/d OPEC production Spare capacity

40,000

35,000

30,000

25,000

20,000

15,000

10,000

5,000

0
Jan-73 Jan-77 Jan-81 Jan-85 Jan-89 Jan-93 Jan-97 Jan-01 Jan-05 Jan-09

Source: EIG, LCMC estimates

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Lost capacity, especially in
OPEC countries, caught
governments and industry
by surprise
And incentivized Riyadh to
accelerate upstream growth
Financial outflows from
commodities is now
pressuring price
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lies at the heart of its political clout both globally and within OPEC. That Saudi Arabia and
other key OPEC countries were caught off guard by the evaporation of surplus capacity
exposed the complacency about their upstream investments. Energy Intelligence Group
pegged surplus production capacity at around 12 mb/d at its peak in 1985 and was eliminated
when Iraq invaded Kuwait and the UN embargoed their oil, yet was still over 5 mb/d as
recently as mid 2002 (Fig. 3). It then virtually disappeared, not as a result of oil capacity
peaking but rather as a result of above-ground politics: the Venezuelan strike in 2002-03,
growing upheaval in Nigeria, Iran’s failure to put in place an acceptable regime for attracting
capital, and the US’ ousting of Saddam. And it was only then that resource nationalism in
Russia and elsewhere reduced the pace of non-OPEC oil production growth.
By 2003-04, Riyadh became concerned about this lost capacity. To be sure the kingdom
responded by raising production (including from the Neutral Zone), which PIW pegs at 7.5
mb/d in mid 2002, growing to 9.2 mb/d (2003), and after falling in 2004, reaching close to
11.0 mb/d in 2008. But by boosting production, Saudi Arabia ate up is spare capacity and
that cushion for the global market dwindled further. In the meantime, Saudi Arabia engaged
in an urgent and massive campaign to increase its production capacity after 2008, and there is
little doubt that campaign is succeeding despite the doubts of peak oilers. PIW estimates that
Saudi capacity rose from 9.5 mb/d in 2002 to 11.8 mb/d today and will climb another 1 mb/d
by 2010, not including rapidly growing gas liquids potential. OPEC’s total production
capacity appears to be heading to well above 37 mb/d by 2010, 5 mb/d above 2002 levels
(before the Venezuelan strike) and a record historical level.
In retrospect the disappearance of OPEC/Saudi spare capacity was the most critical element
in propelling prices from 2003-08, and the reemergence of that capacity should be the most
critical element for at least the next three years, longer if global demand fails to rebound to
its earlier 1.5- 1.8% annual growth level. Here is a short list of the reasons:
• Saudi Arabia will likely wield surplus capacity for its own political ends – keeping
prices moderate to spur economic growth and curry influence internationally as well
as to withhold export earnings from countries whose use of oil revenue is deemed
inimical to the kingdom’s international objectives (e.g. Iran, Venezuela and Russia).
High spare capacity also carries the threat of higher production to ensure discipline
within OPEC’s membership.
• The very existence of surplus capacity overhanging the market will reduce
speculative flows designed to take advantage of a price spike.
• To the degree that the kingdom again defines a price band within which it hopes to
maintain prices, speculative flows will be reluctant to test those limits. At the
moment, Saudi policy appears directed to maintaining a price band of $40-$75.
Tamer financial flows
It now appears that the enormous financial flows that began entering commodities markets in
2003-04, propelling prices upward after that and downward after mid-2008, are going to play
a much more neutral and benign role going forward than they had in recent years. There are
several ways in which financial flows impacted markets over the past five years, mostly
through growing investor activity in financial instruments which provided direct exposure to
Page - 8

Both exchange traded and
off-market open interest is
now falling
The liquidation of passive
investments helped lead the
market down in Q3
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energy (and other commodities) prices, but also through equities and other investments that
provided indirect exposure to the underlying values of commodities.
Evidence of this abounds. Open interest in futures and options on crude oil on the two major
exchanges on which the two are traded – NYMEX and ICE – grew phenomenally from 2004
into 2008, providing the most objective measure of these flows. As 2004 opened there were
some 628,000 futures contracts in open interest on the NYMEX, representing 628 million
barrels of oil. By September the total open interest grew to 1.54 million contracts,
representing over 1.5 billion barrels of oil and the number hovered in a range of 1.35-1.5
million contracts from then until late June/early July 2008, after which open interest entered
a period of time of steady decline well into December of last year, falling back to just over
1.1 million contracts. Adding in open interest in ICE crude oil contracts emphasizes these
trends, as combined NYMEX and ICE open interest grew from 950,000 contracts
(representing nearly 1 billion barrels of crude) in early 2004 to 2.7 million contracts (2.7
billion barrels). As deleveraging took place from mid-2008 to the end of the year about 1
billion barrels (more than one third of total open interest in crude oil) had been liquidated.
The flows into and out of oil, like those into and out of other commodities, were actually
much greater. Adding the flow into and out of options to outstanding flows into crude oil
contracts brings total exposure closer to 7 billion barrels at its peak in 2008. But more
interesting and less easy to track are flows into and out of crude oil via over the counter
contracts, which by our judgment grew from being a fraction of exchange traded crude in
2004 (perhaps some 80% of exchange-traded open interest) to a multiple of exchange-traded
crude by 2008 (probably more than 120%). And the deleveraging that has taken place during
the selloff in the commodities world and other asset classes since mid-2008) was paralleled
in OTC interest, which we estimate to again be a fraction of exchange-traded volumes.
Part of the rise and fall of exchange-traded and OTC crude oil tracks closely total investment
flows into passive investments (index funds, like the S&P/GSCI or the DJ/AIG). These
investments were undertaken largely by pension funds, endowments and some sovereign
wealth funds. While the initial motivation for these investments was asset diversification,
these investments became increasingly attractive in the context of 2004-08, with tightening
markets due largely to higher demand growth in the US, China and elsewhere; surplus
capacity dwindled, further increasing financial flows and pushing prices upward, which only
attracted more investments. It is our judgment that assets under management in these passive
index funds rose phenomenally, especially from 2006 to midsummer 2008, growing from
around $75 billion to $280 billion before falling back by year end to the same level as early
2006. While some of
this outflow is
associated with reduced
asset values, a great deal
of it is the result of
massive liquidation of
positions in passive
investments, as seen in
the figures below.
What was true of
passive investments has
Page - 9

But the market liquidation
appears now to be over
Speculative flows have
diminished as well
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also in my judgment been true of speculative flows affecting the “back end” of the market, or
deferred prices, as well as investments in commodity funds that, unlike index funds, are not
simply long-only but trade long-short largely on the basis of technical factors. It seems to be
the case that somewhere between 15 and 20% of capital flows into commodities came from
passive investors, while another 10-15% came from technical commodity traders. The rise
and decline of commodities prices reflects and is partially caused by the demand for paper
commodities. A regression analysis applied to these flows shows strong causality between
inflow of new capital into these funds and higher prices, as well as outflow and lower prices.
As is clear in the figure above, it now appears that the liquidations which drove markets
through the latter part of 2008 have now been curtailed and that investor flows are likely to
have a far less dramatic impact on prices than was the case during the period 2004-8. Indeed,
the view that prices are likely to fluctuate within a narrower band of $40-75 per barrel
reinforces the conclusion that financial flows into commodity index funds going forward for
much of the next two to three years will be benign.
A similar conclusion relates to speculative flows. The deleveraging that has taken place over
the past six to nine months affected not only passive investors, but also speculators. Among
the many factors at work, two in particular loom large and also reinforce that view that
financial flows will have a significantly reduced impact on prices.
First, there is simply less capital available in hedge funds and from individual investors to
impact the market in a way similar to what happened over the past few years and in
particular over the period September 2007 through June 2008. During this period a sort of
investor frenzy took place, close to a “mass hysteria” among investors, in which high oil
prices were considered to have no impact on the global economy and to be the inevitable
result of higher demand in emerging markets and peak oil. Only much higher prices, it was
thought, could play the dual role of killing demand and encouraging new investments in
supply. Attention was focused on buying deferred oil, which rose from $70 per barrel in
September 2007 to $135 in May 2008. In the four weeks after April 1 alone, it rose from $95
to $130. That money exited rapidly after July, as prices started to fall.
Page - 10

In softer markets the
risk/reward from
speculation is shifted
The decline of the dollar
also spurred speculative
flows into oil…
…and this too is a feature of
the past
The oil market looks
superficially more benign
But darker clouds are on the
horizon
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Second, there were other, even more speculative short term investments, which came in
spurts, including September-October 2007 and late spring 2008. These speculative
investments saw little risk in putting money into deferred oil and significant upside potential
in case of a disruption to supplies. The disruption scenario was fueled by the view that spare
capacities were a factor of the past and that Saudi Arabia’s upstream expenditures could do
little more than keep pace with alleged accelerating depletion of its giant fields, especially
the supergiant Ghawar field. Without spare capacities to replace lost disrupted oil, whenever
perceptions increased of a potential major disruption from a political event – especially one
focused on Iran and its quest for nuclear potential – speculative flows increased. As spare
capacities now are large and growing and expected to remain a major feature of the market
for the next two years, speculative flows designed to generate super earnings with a
disruption will look increasingly like poor bets.
A final financial factor that grew to have an important impact on both passive investor flows
into commodities and on speculative flows relates to the dollar, a currency under increasing
duress as the credit crisis erupted and spread, fueling expectations beginning in September
2007 in particular of rate cuts by the US Federal Reserve Bank prompting higher commodity
prices and precipitating a de-linking of the currencies of Saudi Arabia and other Middle East
producers from the dollar. There was a direct causal link between rising commodity prices
and speculative flows going long the Euro, short the dollar, and long commodities. Here too
there are reasons to believe that over the next few years the impact of the dollar and of
speculative flows will be significantly less pronounced.
History bears this out – before 2007, when it became fashionable in financial circles to
believe there was an inverse relationship between the US Dollar/Euro rate and the dollar
price of commodities, there was in fact no discernible correlation between the two. And now,
even if there were, the likelihood is that the US Federal Reserve’s cut to virtually zero is
being matched by similar cuts by other central banks, and that loose fiscal policy in the US
will be matched by loose fiscal policies elsewhere. In short, the factors that for the past five
years exacerbated price volatility and helped push prices up will no longer be as effectively
at work.
The result: a more benign oil market?
It is tempting to conclude that for the next three years or even longer the oil market will be
less tumultuous than it was for most of this decade. That is both a possibility but also in the
end a false hope. Certainly it is likely that the oil market will see far more limited financial
flows exacerbating price trends than it has in the past half decade and longer. Certainly it is
likely that a tamer market for exploration and production could increase global production
capacity, mirroring the past half decade when resource nationalism constrained the growth in
supply. And certainly it is possible that there will be more opportunities for OECD-type
governance freeing up markets for trade and capital flows will again diminish the temptation
by oil producers to use oil as an instrument of policy.
Even so, darker clouds remain on the horizon. One of these clouds has to do with the
unintended consequences of some of what now see unfolding. Right after the Iran-Iraq war
concluded, in the winter of 1988-89, Saudi Arabia (and Kuwait) started to increase
production to erode prices and deprive both Baghdad and Tehran of oil revenues because of
Page - 11

Softer markets don’t
necessarily limit chances of
political disruptions
Price spikes are more
unlikely, but price volatility
has not necessarily ended
The Middle East still
presents a host of
geopolitical risks
The financial crisis creates
an additional layer of risk
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suspicions about how each country might use the increased revenue associated with higher
production after the war. One consequence of that was Iraq’s taking of Kuwait in the summer
of 1990 and its physical threats to the Arab Gulf oil producers. That should serve as a cogent
reminder that resource wars have not been waged in a high price environment, but they
certainly have in a low price environment. Similarly, lower prices in the late 1990s, again
engineered by Riyadh, aimed to punish Venezuela for eroding Saudi Arabia’s position in the
US market. The result was the election of Hugo Chavez as President of Venezuela. These
historical examples should remind us that the impacts of unintended consequences can be
rather severe.
Additionally, softer markets do not necessarily mean that the chances of political disruption
are more limited. The threat of terrorist attacks in Saudi Arabia might actually increase as
factions in other countries conclude that the kingdom is responsible for lower prices by not
curtailing production enough to push prices back over $100 per barrel. Nor can one rule out
an Israeli attack on Iran’s nuclear facilities, leading to a shutting in of Iranian output in
retaliation, or an Iranian effort to block passage of tankers through the Strait of Hormuz in
the Arabian Gulf. And it remains possible enough for civil strife in Nigeria, Venezuela and
perhaps one other large producer to result in a simultaneous disruption from those three
countries.
What’s more, even though the probability of a price spike remains more remote than it did a
year ago, there is no reason to expect that oil price volatility has come to an end. There are
many factors that have impacted the growing volatility of oil prices. Among these are current
global economic conditions, which have seen the volatility of exchange rates increasing and
impacting the volatility of all oil prices; and even within oil, physical market conditions
themselves, including bottlenecks around the Cushing, Oklahoma pricing hub for WTI have
had a role in enhancing volatility.
Any list of geopolitical risks lurking over oil markets must include a set of factors related to
the Middle East, and it’s hard to prioritize them. Even so, the inevitable departure of the US
from Iraq could unleash political forces that impact oil flows in multiple unexpected ways,
especially if one result is open civil war within the country and its division into successor
states, aping what happened in the Balkans with the breakup of Yugoslavia, with perhaps an
even more bloody result. Nor can one keep from the list a multiplicity of factors related to
Iran – the elections this year, the country’s nuclear ambitions and the reactions of neighbors
and international powers (including the US) to them.
The financial crises confronting a range of resource rich countries provide another long list
of potential nightmares. The list includes Russia and Ukraine, with a question of who
defaults first and with what consequence; it includes Venezuela, Ecuador and Bolivia in
Latin America, the heartland of resource nationalism. Indonesia, Nigeria, Egypt and the other
North African countries are not far behind.
While the future remains uncertain, one trend remains clear: the way the interaction of
politics, geopolitics, and financial flows impacted oil prices between 2003 and 2008, is
unlikely to persist during the next two years and beyond. But even in an atmosphere of lower
prices, these dynamics are well worth watching; the fabric of the last five years may have
Page - 12
 SPECIAL REPORT

unraveled, but the threads are just now beginning to form a fresh pattern. A new world of
geopolitics is emerging and it is still too early to determine when circumstances will warrant
a revaluation of this new world.

NEW YORK
Pierre Houri
+1 212 398 3650
phouri@louiscapital.com

Pierre Lacaze
+1 212 398 1230
placaze@lcmcommodities.com

LONDON
Ben Kelly
+44 207 726 4084
bkelly@louiscapital.com

HONG KONG
Alex Colin Jones
+852 3793 1101
ajones@louiscapital.com

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