Last week in Oil Colosseum (I) , we delved into the prevailing fear of global oil scarcity which primarily stemmed from the Peak Oil Theory. This theory suggests that global oil production would reach its peak in the year 2000, marking the end of growth in global consumption. Regardless of the accuracy of the Peak Oil Theory, it indeed, sowed the seeds of disputes. Amidst the interactions among nations, Seven Sisters and major oil-producing countries entangled in battles for ownership and supply rights to oil resources, ultimately leading to the energy crises of the 1970s and dramatic oil price spikes. This week, we will continue our journey, unravelling how the United States leveraged the Petrodollar system to supplant the Bretton Woods Agreement, securing its global leadership position, and examining the geopolitical disputes that arose in the quest for oil pricing dominance in the new century.

Summary

• The rapid devaluation of the U.S. dollar after the 1971 decoupling from gold prompted a decline in income for the Organization of the Petroleum Exporting Countries (OPEC). OPEC initiated the use of gold pricing, allowing inflation to seep into oil prices, unfolding the first oil crisis.
• In October 1973, the Yom Kippur War (the Fourth Middle East War) concluded with Israel gaining more Arab territories. In retaliation for U.S. and European support of Israel, OPEC significantly reduced production and imposed oil embargoes, causing oil prices to quadruple and resulting in the most severe post-World War II economic crisis, reshaping the global industrial landscape.
• Following the first oil crisis, the United States reached an agreement with Saudi Arabia through military support in exchange for pricing oil in U.S. dollars. This move secured the demand for the USD globally and reinforced its position by authorizing the Federal Reserve to print unlimited dollars.
• In 1979, Iran underwent a political transformation from a pro-American nation to an anti-American one. Subsequently, the eight-year Iran-Iraq War further disrupted oil supplies. Middle Eastern nations, driven by fears of oil depletion, set production limits, sparking the second oil crisis.
• Since the 1980s, an ongoing series of geopolitical conflicts of varying scales have unfolded worldwide in the pursuit of oil pricing dominance. In the past decade, the global oil supply structure has evolved to feature a tripartite balance between Saudi Arabia, Russia, and the United States.

The First Oil Crisis

In the wake of World War II, the United States solidified its position as the world's economic powerhouse, and in 1946, the Bretton Woods Agreement established the gold standard. Under this system, countries agreed to maintain their currency exchange rates within approximately 1% of the USD, which was fixed at $35 per ounce of gold. With nearly 80% of the world's gold held in U.S. reserves, the U.S. dollar's value was underpinned by the economic might of the United States.  

However, the United States faced a challenge in ensuring that the open market price of gold did not exceed the fixed $35 per ounce. To maintain this peg, the U.S. had to release increasing amounts of gold from its reserves to suppress rising gold prices, which was ultimately unsustainable. By the late 1960s, the cost of the Vietnam War, which had exceeded $200 billion, had pushed the United States into mounting debt. This resulted in rapidly rising trade deficits and the depletion of U.S. gold reserves, as foreign-held U.S. dollars surpassed these reserves. In August 1971, the Nixon administration announced the end of the U.S. dollar's convertibility to gold, and the subsequent Smithsonian Agreement of December 1971 officially devalued the U.S. dollar by 8%, setting the new gold price at $38 per ounce. The U.S. dollar, along with other pegged currencies, transitioned to a floating exchange rate system.

In the early 1970s, as the U.S. dollar depreciated, OPEC nations, which priced oil in U.S. dollars, experienced a reduction in their income. Consequently, OPEC began to use gold, rather than the USD, as the basis for oil pricing. This switch introduced rapid inflation into various commodity prices, including oil. Between 1970 and 1973, oil prices surged from $1.80 per barrel to $3.29 per barrel, marking the commencement of the first oil crisis.

From a geopolitical standpoint, tensions were escalating in the Middle East due to the Israel-Arab conflict. After Israel's victory in the 1967 Six-Day War, which saw them occupy large portions of Arab territories, the 1973 Yom Kippur War began, with Egypt and Syria launching attacks to regain their lost territories. However, Israel swiftly retaliated, and it was only after a United Nations ceasefire that they managed to gain even more territory.

Due to U.S. and European financial support, along with military aid to Israel during several Middle East conflicts, Arab nations grew increasingly hostile toward the United States, Europe, and Israel. In response, they chose to use oil as a political weapon. In October 1973, as a result of the Yom Kippur War, OPEC declared a 5% monthly reduction in oil production until Israel returned all the territories occupied since the Six-Day War. Saudi Arabia even imposed an oil embargo on the United States to compel them to stop supporting Israel. After the ceasefire, OPEC directly further cut production by 25%, leading to a worldwide daily oil supply reduction of approximately 4 million barrels, nearly 7%.  

By the end of 1973, oil prices had surged to $12 per barrel, marking a fourfold increase compared to pre-crisis levels. This elevated oil price level persisted until 1978 without any significant decline. The oil embargo had widespread repercussions. In 1974, the U.S. economy contracted by 2.5%, industrial production plummeted by 14%, and Japan saw a reduction of over 20% in its industrial output. Globally, unemployment and inflation rates soared, with approximately 18.5 million people unemployed in capitalist nations. In the United States, the unemployment rate surged to 9.1%, and the CPI escalated from 6.2% to 11%. The financial sector experienced significant turbulence, with over 180 U.S. banks going bankrupt, more than 120,000 companies with assets exceeding $1 million collapsing in Western nations. The S&P 500 index, which stood at 111 at the outbreak of the 1973 war, plunged to 62 within a year, marking a staggering 44% decline. In the United Kingdom, stock prices witnessed a decline exceeding that of the early 1930s. This period is historically known as the First Oil Crisis, which had profound and far-reaching effects on the economic development of developed countries.

Petrodollars

The Bretton Woods system initially established the interchangeability of the U.S. dollar and gold, serving as a safeguard against competitive currency devaluation and fostering global economic growth. However, to meet the growing demand for dollars, the U.S. government resorted to money printing, resulting in virtually cost-free imports for the United States. This influx of dollars, though, led to long-term inflation.

Following the first oil crisis, substantial wealth shifted to emerging oil-producing nations, posing a fresh challenge to U.S. dominance. Disagreements also emerged within Western alliances. Western Europe, heavily reliant on oil imports, began re-evaluating its Middle East policies. Japan shifted its investments from oil-intensive industries to electronics, and fuel-efficient Japanese cars gained global popularity over American models.

The "Seven Sisters," the dominant oil conglomerate, initially reaped the rewards of the surging oil prices during the crisis. Nevertheless, the spheres of their influence gradually waned, leading to their evolution into prominent entities primarily engaged in the refining and distribution of oil within the downstream sector. Preceding the merger in 2000, the "Seven Sisters" metamorphosed into today's "Four Horsemen," consisting of ExxonMobil, ChevronTexaco from the United States, and British Petroleum and Shell. Collectively, these four industry behemoths now command 13% of global crude oil production and control 3% of the world's oil and gas reserves. This is a notable shift from their earlier position, holding an 85% share of oil reserves prior to 1973. In the interim, state-owned oil corporations ascended to prominence, including Saudi Aramco, Iraq National Oil, Iran National Oil, Rosneft, and PetroChina, which together oversee 30% of global crude oil production and control 44% of the world's oil reserves.

In the year 1974, as the United States confronted a formidable bout of inflation and sought to alleviate its trade deficits, it found itself compelled to curtail the production of newly minted U.S. banknotes. Nonetheless, American leadership, spearheaded by Henry Kissinger and his contemporaries in Washington, were disinclined to traverse this particular avenue. Instead, they aimed to perpetuate the fabricated demand for the U.S. dollar as a means of upholding the United States' global pre-eminence. To this end, they judiciously selected oil as a surrogate for gold, engineering a sophisticated Petrodollar recycling system. This shrewdly crafted arrangement included an accord with Saudi Arabia. The United States, in exchange for safeguarding Saudi oil fields and providing weaponry, successfully persuaded Saudi Arabia to denominate all of its oil transactions in U.S. dollars and to channel the surplus profits from oil sales into U.S. Treasuries held in European and American financial institutions. In light of Saudi Arabia's status as the world's premier oil producer at that time, its influence was such that it led to the unanimous decision of all OPEC member states in 1975 to exclusively employ the U.S. dollar as the universal pricing currency.  

Hence, owing to the Federal Reserve's boundless capacity to produce currency and have the global community underwrite this endeavor, the United States effectively secured the privilege of importing global oil at minimal expense. In tandem with the escalating global demand for oil, there was a commensurate rise in the demand for U.S. dollars. Consequently, the U.S. dollar's role as the global reserve currency experienced a soaring ascent. This development empowered the Federal Reserve to engage in credit expansion and an enlargement of the monetary supply, ultimately facilitating an economic resurgence and concurrently contributing to the decline of the Soviet Union.

The Second Oil Crisis and the Shift Towards Multipolarity  

In 1979, the Iranian Revolution, resulting in the ousting of the pro-American Shah, led to a complete cessation of Iran's oil exports. Simultaneously, Saudi Arabia, fearing the potential depletion of oil resources, imposed a daily production cap of 8.5 million barrels. The decline in oil production disrupted the supply chain for oil conglomerates. Consequently, oil prices surged from $12.8 per barrel in 1979 to $40 per barrel. The 1980s witnessed the Iran-Iraq War, further unsettling the oil supply. The United States, Germany, and Japan began establishing strategic oil reserves.

The second oil crisis triggered substantial and widespread price increases. High oil prices once again delivered a blow to the U.S. economy. In 1980, the inflation rate in the US skyrocketed to 14.8%, and the trade deficit hit a new record of $36.4 billion. The number of business closures sharply increased, and the unemployment rate soared to 10.8%. The United States entered a period of stagflation. During this period, the legendary Paul Volcker assumed the position of Chairman of the Federal Reserve and employed historically aggressive interest rate hikes to combat inflation. This, combined with Reaganomics' tax cuts and reduced government spending, finally revitalized the U.S. economy in late 1980s.  

Following 1986, an oil surplus sent prices tumbling into the $10-20 range. The disintegration of the Soviet Union during the 1990s and the East Asian economic crisis contributed to lower oil prices. The onset of globalization and high-tech trends in the 2000s triggered a revival in the oil market, a trend that persisted until the 2008 financial crisis. Over the past decade, oil prices have been subject to fluctuations due to the global economy's instability.

Yet, the struggles over oil never subsided. In 1990, Iraq's invasion of Kuwait, driven by discontent over Kuwait's oil production surpassing its allotted quota, led to a swift military response from the United States aimed at securing its Middle Eastern allies. In 2002, Iraq, the world's second-largest holder of oil reserves at the time, under Saddam Hussein's leadership, became the first OPEC member to price its oil transactions in Euros. Simultaneously, Saudi Arabia started amassing a substantial reserve of 30 billion Euros. The Petrodollar system displayed signs of vulnerability. Following the U.S. invasion of Iraq after its occupation, oil pricing swiftly reverted to the previous norm of U.S. dollars. Saudi Arabia, too, shifted its stance, asserting that the euro's advantage was not yet apparent. In 2011, Libyan leader Muammar Gaddafi sought to expedite support for a gold dinar in Africa, as an alternative to pricing oil independent of the U.S. dollar. Subsequently, NATO intervention in Libya led to the execution of Gaddafi, who had been at odds with the West since 1969.  

Since the 1980s, countries such as the United States, Russia, Norway, Canada, and Colombia have unearthed new oil fields. Most notably, the breakthrough in shale oil technology in the 21st century propelled the United States to outstrip Saudi Arabia and Russia, becoming the world's largest holder of oil reserves and oil production. OPEC's authority over oil prices gradually waned, and the dynamics of oil supply and demand evolved into a multipolar landscape. Consequently, the Petrodollar system also grappled with challenges posed by the Euro and the Chinese yuan.

The Oil Colosseum Amid Geopolitical Conflicts in the Last Decade

In 2014, the U.S. Federal Reserve announced the end of its quantitative easing program, raising concerns within OPEC about the increasing market share of U.S. shale oil. In response, OPEC decided to increase production, aiming to trigger a price war that would force high-cost shale oil companies into bankruptcy. This oversupply led to a substantial drop in crude oil prices, falling below $40 per barrel for the first time since the European debt crisis. However, advancements in shale oil technology resulted in even lower production costs, causing OPEC's strategy to backfire. By 2016, OPEC found itself unable to sustain prolonged low oil prices. Combined with U.S. sanctions against Iran, this eventually led to a production cut agreement, pushing oil prices up from 2016 to 2018. During this time, the global oil supply system transformed into a three-way competition involving OPEC, Russia, and the United States.

In 2020, the global COVID-19 pandemic caused crude oil prices to drop into negative territory. This was, in part, due to a group of London-based traders who offloaded a significant portion of May futures contracts, representing 29.2% of the total WTI global trading volume. This sudden oversupply drove prices down to -$37.63 per barrel, marking the first time in history that oil traded at negative values. As the global economy experienced an extended downturn, industrialized nations stockpiled oil as part of their strategic reserves, causing demand to plummet. The U.S. faced storage capacity constraints, and traders unwilling to take physical delivery of oil struggled to find buyers, leading to the unusual scenario of negative futures prices.

In 2021, extreme weather conditions, including one of the hottest Julys on record, led to a surge in natural gas prices in the United States. Natural gas became the second most important strategic energy source after crude oil, and there was a simultaneous increase in demand for diesel, a downstream product of crude oil.

In 2022, the Russia-Ukraine conflict took center stage. In 2021, Russia produced 3.96 billion barrels of crude oil, representing 13% of global output, with 1.9 billion barrels directly exported, accounting for 13% of global exports. Russia transported its crude oil through two primary routes: pipelines, such as the Druzhba (Friendship) system, delivering oil to the European Union, and seaborne tankers through the ESPO (Eastern Siberia-Pacific Ocean) system, supplying China. The remaining Russian crude oil was transported by sea, albeit in smaller quantities.

With the outbreak of the Russia-Ukraine war, Brent crude oil prices once again crossed the $100 mark, a level not seen since the 2008 financial crisis. European Union countries initiated an oil embargo against Russia at the same time, prohibiting the import of Russian crude oil and imposing a price cap of $60 per barrel. This embargo aimed to significantly reduce Russia's income while stabilizing global oil prices, ultimately cutting off Russia’s financial resources for the war against Ukraine. However, the embargo produced mixed results. On one hand, Russia successfully shifted its supply system toward the Asian market. On the other, sanctions against Russian oil had a retaliatory impact. In the event of a harsh winter, European countries would need to pay higher prices for energy on the global market, potentially risking economic stagnation in the current high-interest rate environment.  

Investment Ideas

As we look ahead to 2023, the 50th anniversary of the Yom Kippur War coincides with new conflicts erupting between Israel and Palestine. Along with the effect of Saudi Arabia and Russia extending their production cut agreement until year-end, Brent crude oil has surged from $71 per barrel in June to its current level of over $90 per barrel. Although the international oil supply landscape has fundamentally shifted from OPEC's dominance 50 years ago, Middle Eastern nations still wield significant influence over oil prices, contributing to more than 30% of global production. The market is closely monitoring whether Iran will become involved in the conflict. While Iran's foreign minister announced this Tuesday that they do not support an escalation of the conflict, the possibility of their participation cannot be ruled out. If Middle Eastern nations are drawn into the conflict, oil prices could potentially cross the $100 threshold again, leaving central banks in Europe and the United States facing a challenging situation in times of high inflation.

Considering the large-scale release of strategic oil reserves by the United States in 2022 and the limited long-term production capacity and bottlenecks of the U.S. shale oil industry, global capital spending on oil remains insufficient. Meanwhile, global crude oil demand is expected to continue growing for the next three years. We believe that the global oil supply and demand will remain tight for many years, potentially keeping oil prices at higher levels in the medium to long term.