Chris Sanders Talk - NATO: Out of Area, Out of Oil

NATO: Out of Area, Out of Oil

ASPO July 18-20, 2006 Pisa

Chris Sanders


In this short talk we are going to examine the impact of a shift in the centre of gravity of the oil and gas industry away from the Anglo-American Atlantic West, east to the Russian dominated heart of Central Asia. We are going to see how this shift in power implies a shift in corporate profitability and ultimately threatens the very nature of the Anglo-American political economy, an international system based on the control of cash flows employing centralised control of the finance, real estate retail and manufacturing industries.


The US is commonly thought of as a liberal-capitalist free-market democratic republic. Regardless of one’s subjective political leanings, this commonly accepted template has implications for the analyst. For instance, we assume as economists that business works to maximise profit by improving its competitiveness, an idea most commonly associated with productivity. Actually, things are quite different.



Take the Pentagon for instance. We usually think of armies, navies and the like. Actually, the Pentagon is the world’s biggest investment bank and industrial combine, with a work force of more than six million people, an operating budget of over $500 billion, and a total annual spend on national security on a GAAP basis of about $1 trillion. The market capitalisation of the top fifty corporate contractors through whom the Pentagon purchases goods and services is more than $1.5 trillion. You may not be aware, however, that their contracts with the military are cost-plus, and have been since the early 1960s.

[Point to Military Node then CLICK]




This is great business if you can get it. The Pentagon provides venture capital as well, so that the companies do not absorb any undue risk in designing and building new weapons systems. The point for us here is that when your profit margin is guaranteed, your profits become positively correlated to costs, and productivity is how well you lobby for contracts, not how efficiently you manage your production process.

[Point to Production Node then CLICK]


Or take the retail trade in the US, the consumer’s paradise. Total sales in the US retail sector are on the order of $1,791 billion, of which fully 14% were generated by one company, Wal-Mart, which employs more than 1.3 million people, or nearly 8% of the country’s labour employed in the retail sector. Wal-Mart alone is a huge force in US international trade, with an Asian manufacturing base supplying its US and increasingly European and Brazilian markets. Anyone who thinks that it is just the Chinese who like a weak Yuan and a strong dollar should think again.

[Point to Finance Node then CLICK]



Look at banking, where consolidation over the course of thirty years and wealthy political action committees have resulted in the repeal of the legal barriers to bank investment in industrial companies, insurance and so on that were legislated in the 1930s. And of course the sine qua non of monopoly, the Federal Reserve System, is in fact owned by the banks it regulates. Yes, you may say, but the board of governors of the system is appointed by the President and approved by Congress. This prevents the industry from exerting undue influence over policy.

Well, consider this. An ex-chairman of Goldman Sachs is the head of the president’s Council of Economic Advisers and also chairs the White House Intelligence Committee. Another ex-chairman of Goldman Sachs is the Secretary of the Treasury. And yet another former senior executive from Goldman Sachs is the White House Chief of Staff.

[Point to Government Node then CLICK]



That kind of influence is what has made it possible for the banking industry, championed by the Federal Reserve, to build an off-balance sheet balance sheet in the form of financial derivatives contracts worth more than $1 trillion dollars, self-regulated, which is to say priced by the banks, and which allows the banks to shift the risk on their balance sheets onto the public.

What a wondrous modern age we live in.

The housing market is one of the biggest industries in the country. The construction of homes, their sales and their financing are the pivot on which the entire so-called private sector turns. Most of the financing in the sector passes at one stage or another through three institutions called government sponsored enterprises, The Federal National Mortgage Association, The Federal Home Loan Banking Corporation, and the Federal Home Loan Banking System. These companies purchase home loans originated by banks and convert them into pools of mortgages that then are bundled into bonds and resold. Then there is the Department of Housing and Urban Development, a Federal Agency which is in the same business that is second in size only to the Pentagon itself.

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[Point to Ideology Node then CLICK]


Finally, there is the media and the system of higher education. Most of the broadcasting and print media in the country is owned and controlled by five corporations. The business schools retooled in the late 70s to turn out graduates versed in finance as opposed to production. And University departments as diverse as sociology, psychology, physics, computer science and area studies depend for their existence on government grants, much of the money being sourced from the military and the intelligence services. .


This is not a free market economy. It is a war economy.


It does not operate in isolation. The alliance system built by the US since world war two was based on an economic trade-off for strategic benefits,


which allowed the US to create a system of bases protecting the access of its corporations to resources and controlling the access of others to those same resources. The economic trade-off was access to the US markets for those key allies, especially Japan and Germany, into which US corporations poured billions in investment capital.



Reinvesting their dollar export earnings in the US capital markets allowed the US access to credit with which to maintain demand growth. Underpinning the economics is control of global trade in oil which, denominated in dollars, has assured the United States of a market for dollars that it creates, literally allowing it to trade paper, or today bits and bytes of data representing money, for real things.


During the years of the Cold War, this is the system that governed what we loosely call The West. Since the collapse of the Soviet Union it has absorbed the former Soviet Union, China and India into a world monetary system that is dominated by the US, abetted by the European Union, and financed by Asia. Every region of the world today is a net lender to the United States, which we can see graphically in the large and growing current account deficits that the US runs with those regions.


Now the prospective end of the first half of the Age of Oil is most commonly addressed as a financial and engineering problem. Financial, so the argument goes, insofar as two or three decades of underinvestment in commodities has resulted in too little supply. Engineering, inasmuch as the necessity of finding alternatives is basically a matter of first finding adequate investment capital after which it is simply a matter of the market and scientific progress doing their work to create alternatives to oil and gas.

There is valid precedent underlying this point of view, of course. After all, the transitions from wood to coal and from coal to oil were managed against a backdrop of what appears to the collective memory to have been a linear march of progress onwards and upwards.


Viewed through the lens of geopolitics though, things look different. The transition from wood to coal initially favoured newly industrialising Britain thanks to her abundant coal resources. The transition that followed from coal to oil at the dawn of the twentieth century was, from financial and scientific point of view fairly straightforward perhaps. But two world wars were fought in the first half of the 20th century largely because one alliance was trying to get access to oil and the other was trying to deny that access. The deniers won.


The point here is that what looks straightforward from the perspective of the market trading floor, the scientific laboratory or the wellhead is something else altogether when the human element and the will to power are introduced. For the millions who died in the two world wars the transition from coal to oil was a major discontinuity. It is neither a coincidence nor insignificant that the fighting in the current world war to control the world energy net has been in the Balkans and latterly in Afghanistan and Iraq. In each case, what is at issue is control of energy supply and distribution.


The reason for this is simple enough, and is made abundantly clear from the oil and gas clocks showing world oil and gas reserve distribution. It is in the Persian Gulf and the former Soviet Union, mostly Russia, that the world’s remaining gas and oil reserves lie. This represents a substantial shift in the fulcrum of world power. For the first time in the history of the oil age the marginal barrels of crude oil and cubic feet of natural gas are not directly controlled by the Anglo-American powers.



The glue that has held together the world industrial economy embodied by the OECD is beginning to dissolve in the solvent of peaking world oil and gas production. OECD oil production peaked ten years ago. The industrial world has to look further and further afield for its oil and gas. This includes buying oil and gas from its former enemy, Russia, and facing the reality that the interests of producers are not identical with those of the consuming countries. More exactly, they are not aligned with the interests of those who rule the consuming countries.


Since American lower forty-eight oil production peaked in 1970, American policy has focused on controlling access to the oil and gas supplies of the Persian Gulf. The difficulty faced by the United States has been its inability to control both sides of the Gulf since the Iranian Revolution ousted the Shah. If the solution to the challenge of peak oil were simply a matter of combining sufficient investment capital with exploration and extraction technologies this would not be an intractable problem. However, as we know today, the limits of recoverable oil and gas are neither financial nor technical, they are geologic.


This implies a step change in the price of energy, as well as a long period of increased volatility in prices until supply from alternative sources can be matched to the shortfall of oil and gas relative to demand. This is as far as one usually gets with an analysis of the impact of peaking oil and gas production on the world economy, and is still well within the comfort zone of most analysts.


This may be a mistake. To begin to see why, we might look at the yield curve, that is to say the term structure of interest rates.


This is usually restricted to an analysis of paper debt, that is to say, cash, bills and bonds. This is actually incomplete. Real money, for instance, that is to say gold and silver, is left out. The reason for this is that the world no longer has a de jure monetary connection to gold. This was lost in 1971, the year that the United States abrogated its obligation to exchange dollars for gold at a fixed price. It is no coincidence, I believe, that this happened immediately after the peak of US lower 48 oil production.


Since then, gold has been commodified, meaning that trade in it is open to the public, which it had not been, in the US at least, since its ownership was criminalised by the Roosevelt administration. Nor is it legal tender, which it once was, in which form it served as a commonly accepted store of value, enabling borrowers and lenders to exchange capital with confidence, knowing, thanks to the value of gold, the relative value of their transactions.


One can change the rules but one cannot change behaviour, and gold is still a monetary asset, whatever the world’s bankers may tell us, as anyone can plainly see from the fact that the bankers continue to hold quite a bit of it themselves, and it is still an important reserve asset. However, the time value of money and the interest rates that represent it are paid in paper money, not gold. If you want to own gold, you have to pay transactions fees and storage costs, which, as it happens, have been going up in recent years. This means there is a negative interest rate for owning real money.


At the other end of the yield curve, bonds are in fact not the only asset. So are equities, which are claims on the current and future assets and income streams of businesses. And there is real property, which also carries with it a rate of return. These asset classes represent, in effect, the collateral against which the debt at the other end of the yield curve issued. It is confidence in future growth, quantified in the prices of these assets that provides the rationale for issuance of debt today in exchange for repayment tomorrow.


Keep this picture in mind, because it is important to our discussion going forward. A step change up in the price of oil due to Peak Production being reached is going to force a rise in the yield on corporate and real property assets. This means that the price of those assets relative to the income they generate, and relative to the assets at the short end of the yield curve – especially gold – is going to have to fall.


To understand why, consider the model of the American economy with which we started this talk. This is a model built on the twin foundations of debt and consumption, both predicated on cheap oil and gas to fuel the cars trucks and aircraft and to cool the warehouses, offices, homes and IT centres.


A cursory look at conurbations like Phoenix and Las Vegas is enough to see the challenges posed by a significant increase in energy costs. But if you doubt the long term impact, let’s look at the markets themselves.


Here is a chart of oil measured in terms of the number of hours of work that it takes to produce a barrel of the stuff. We can see that oil prices fell in real terms for nearly a century before vaulting in the 1970s. In the 80s the triple impact of recession, conservation, and high output, especially in Saudi Arabia, led to a fall, reaching new lows in 1998. Since then the value of a barrel in hours worked has more than doubled. .




Let’s look at this now in comparison to the real value of corporate America, measured by the S&P 500 deflated by CPI. This is a pretty arresting picture. The inverse correlation between corporate asset values and real oil prices could not be clearer.


Now logically, if oil prices were simply a function of finance and exploration this would not be a big deal, just one more credit cycle. But we know that is not the case. Oil prices are now a function of geology too. We have already discovered pretty much what there is to discover. From now on scarcity places a floor under relative oil prices. And that implies that there is a ceiling, for the time being at least, on corporate and real property values.


The finance model that lies at the base of the US political economy is no longer viable. This depends on unlimited housing development utilising cheap space and cheap energy. The sort of horizontal urban development so loved by US planners and politicians who thrive on the cash cycled through the permit, building, sale, mortgage and remortgage process is no longer profitable on anything other than the shortest term payback period. This represents nothing less than an existential crisis for the American political class.


No wonder they invaded Iraq. And no wonder they are picking a fight with Iran. Without control of Iranian oil and gas they have no hope of securing the Middle East. For that they need to control both sides of the Persian Gulf.

But Iran has applied for membership in the Shanghai Cooperation Organisation, and speaks openly of an oil and gas axis stretching from the arctic to the Persian Gulf. It does not have the West in mind, except as a customer.


Look to Russia, and remember John D. Rockefeller. Vladimir Putin may well be his equivalent for the Twenty First Century.