Third oil shock

by Matein Khalid

The two oil shocks of the 1970's had a seismic impact on the world's industrial constellation, financial markets, geopolitical alignments and competition for energy resources.

Stagflation in the US, the worst economic recession since the Great Depression, a monetary policy revaluation under the Volcker Fed, twenty per cent inflation and Treasury bill rates, stock market crashes, international banking failures and the sovereign bankruptcy of Latin America, the collapse of British trade unions and American airlines, the emergence of Saudi Arabia as the power broker of the Arab world, the Reagan-Thatcher free market ideologies can all be traced to the 1979 oil shock when Ayatollah Khomeini overthrew the Shah's regime in Iran.

We are now living in one of history's defining moments, the third oil shock when North Sea Brent and West Texas crude trade at $110. The third oil shock will change the world as we know it, create new realities of geopolitical power and influence.

Technology, politics, financial markets, climate change, exploration trends in natural gas and coal, banking systems, the war on terror, central bank monetary policies, commodities prices, business processes and strategies, even social norms will not be immune from the third oil shock. That much, at least, is certain.

The end of the Cold War and the collapse of the USSR left the US as the planet's sole superpower, with its Washington consensus the dominant economic paradigm enforced by the IMF and the World Bank after the 1998 debt crises in Russia and the Far East. Yet the first decade of the new millennium, the reign of George W Bush in the White House, has not been kind to Pax Americana.

The enlargement of the EU, wars in Iraq and Afghanistan, the rise of Islamic fundamentalism in the Middle East, the resurgence of Russia, the Silicon Valley tech bubble bust, 9/11, the failure to contain Iran or crush Hezbollah, Hamas and Al Qaeda terrorism, colossal current account deficits, the Wall Street credit meltdown and the collapse of the US dollar in the foreign exchange markets all demonstrate the decline of American power in the world. The third oil shock will accelerate this trend.

Russia, with its $500 billion hard currency reserves and ownership of one fourth of the world's gas reserves, has stymied Western oil companies' ambitions to own equity gas.

The Kremlin has arm twisted Shell to give up control of its Sakhalin project to Gazprom and used its energy resources as an instrument of foreign policy from Kiev to Berlin, Tashkent to Beijing, Tbilisi to Qom.

Pax Americana in the Middle East also faces grave threats in the future. Iran's Ayatollahs, also beneficiaries of $110 crude oil, have forged an anti-American, anti-status quo alliance that embraces, Syria, Hezbollah in Lebanon, Gaza in Palestine and Shia militias in Iran.

While US allies like Egypt, Saudi Arabia, Jordan and the GCC states have not abandoned Washington's security umbrella, their economic linkages with China and Russia have become crucial.

The US, with its consumption excesses, crippled money centre banks, collapsing dollar, impotent Treasury and current account deficits is hardly a persuasive economic role model for the Arab world.

This is a revolutionary U-turn from the early 1990's when America won the Gulf War, the Soviet Union disappeared into the garbage heap of history, the IMF and Wall Street were the world's financiers and the dollar was king in the currency markets.

If Clinton or Obama win the White House in November, $110 crude oil can easily persuade America to embrace the new ideas on climate change and energy, as happened with Japan, Taiwan and South Korea after the economic insecurities of the second oil shocks.

Washington will use regulations and the tax code to force consumers, utilities and businesses to embrace fuel efficient protocols, meaning the golden age of the gas guzzler SUV and the light truck is living on borrowed time.

Detroit's future may rise in hydrogen cars and diesel trucks. Of course, every oil shock contains the seeds of its own destruction. The US consumer is no less than 20 per cent of the global GDP and the buyer of the last resort for Asia's exports that define the demand curve for oil and gas. As in 1974 and 1982, economic recession in the West could well mean yet another historic collapse in crude oil prices.

Of course, since the US is no longer the world's sole economic superpower, China has emerged from behind the Bamboo Curtain and India has abandoned the License Raj, the world's ability to recycle petrodollar surpluses is that much greater.

Yet chronic inflation, fed by soaring prices of gasoline, heating oil, cement, grains and construction equipment, has become the macroeconomic Achilles heel of Russia, the GCC, India, China and the EU. As in the 1970's higher inflation rates increase political risk for incumbent regimes across the emerging markets because the masses are often the victims, not beneficiaries of inflation.

This is the ominous message a capricious electorate delivered to General Musharraf in Pakistan, to Abdullah Badawi in Malaysia, to the South Korean socialist coalition in Seoul. If oil, food, cement and fertiliser prices continue to soar, the Tories will oust New Labour from Downing Street, the Congress-Left Front will lose the next Indian general election, riots and demonstrations could even challenge the dictatorships of the Arab world.

The impact of $110 oil on the GCC will naturally accelerate the region's economic transformation. Saudi Arabia, Qatar and the UAE will see trade surpluses soar as well as imports, defence spending, remittance flows, central bank and sovereign wealth fund reserves.

Algeria, with its large population and chronic unemployment, will find it difficult not to raise food subsidies with its $50 billion petrodollar war chest. Libya has become the newest province of black gold after Colonel Gaddifi's diplomatic U-turn with Washington, the lifting of UN sanctions and the $2.5 billion settlement for the Pan Am Jumbo jet his intelligence agents destroyed in the skies above Lockerbie, Scotland.

The EU, Turkey, China, India, Taiwan, Japan, South Korea are all significant importers of oil and gas. The impact of $110 crude oil and soaring food prices, Asian trade surpluses will fall, even get wiped out in the decade ahead. Asian export growth could well decelerate, if not collapse, as happened after the 1979 oil shock and global economic recession.

This is the SOS flashed by the bear markets that have gripped Asian stock exchanges since October, with the grizzles run amok on Japan's Nikkei, Hong Kong's Hang Seng, India's Sensex and Singapore's Straits times Index. Vietnam, the darling of Wall Street, has lost half its market value.

The Istanbul stock exchange reflects the political time bomb that is $110 crude oil on Turkish politics and the stock market with a $40 billion current account deficit, a military high command whose secular Kemalist values are threatened by the Islamist AKP government of Prime Minister Erdogan, a PKK Kurdish insurrection, Turkey can ill afford another financial crisis and run on the lira. India, with 70 per cent dependence on imported oil, will scramble for Burmese gas even as kerosene, cooking oil and gasoline demand soars.

Indian dependence on capricious foreign capital is its Achilles heel in a world where emerging markets risk aversion spikes and Manmohan Singh's $400 billion infrastructure bonanza is a pipe dream in a world of $110 oil.

Pakistan, with its $7 billion current account deficit, faces grave risk from the third oil shock. The 1970's oil shock doomed ZA Bhutto's PPP. Will the third oil shock derail his son in law Asif Zardari's moment of power?

(The writer is a Dubai-based investment banker and economic analyst)

Khaleej Times