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What the looming oil crisis means for gold

When these separate problems join together, much more than higher oil prices will be at stake...

Global Watch: 10th April 2007
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THE WORLD'S OIL supplies reside in nations not only involved in conflict between their local branches of Islam, but in nations that loathe the West, particularly the US of A.

   Now add to this the wealth these countries themselves have in their pockets. It's sufficient to influence the flow of US Dollars to the Dollar's detriment, a market that is already under pressure from an over issuance of the currency to support the yawning US trade deficit.

   Now add to that the changing balance of economic power, slowly shifting from West to East. Consequently the oil price is a very fragile thermometer of all these problems.

   On the surface, responsible forecasters predict oil prices dropping to $50 per barrel. But already at the early stage of the oil year, it has climbed back to the mid-$60 level.

   And we also have media attention focused on the symptoms of these problems separately. The TV and newspapers fail to bring them together as one would see tributaries of a river coming together to make a more powerful and major force.

   What is the present state of these tributary problems? Will flooding happen downstream?

US demand for oil

   First, the US consumer. He has been and continues to be the force driving the growth in the US economy – and with it, US oil demand. What condition is he in? With gasoline topping $3 a gallon, you may expect the US consumer to now tailor his needs to lower consumption. But it seems this is just not happening.

   Frankly, if we all need to drive somewhere, then we need to drive somewhere. We won’t cut back on petrol before cutting back in other areas first. Yes, we may stop driving to the shops for one or two items when we run out, or make a list to shop once in a while. But this is not enough to force a cut back in total demand.

   Indeed, demand is showing itself to be relatively price insensitive at the current level. The US economy continues to grow and wage pressures are gaining more power as unemployment drops. So the consumer's ability to fund the higher cost of petrol is gaining strength.

   The US Department of Energy has stated it is not comfortable with current global crude oil supplies, although US stocks are adequate to meet gasoline demand this summer. If the DoE is correct in its view of tight oil supply, then we will be proved right in our view of the oil market as moving forward to a shortage eventually, taking oil prices much higher.

War with Iran?

   What about Iran – would one be correct in thinking that it is the Iranian political problem that is pushing up the price? Despite the seeming relief provided by the release of the British sailors from Iran, the high prices do persist, so pointing to more than an unlikely war with Iran.

   Why unlikely I hear you cry? What is the political cost likely to be to the States where the President is for the war and both houses are against it? Only an emasculation of the foreign policy of the States and its Middle East policies, which are already looking more than questionable.

   What of the appetite of the US public for war in the Middle East? We believe it is dwindling fast.

   What are the possibilities that, if Iran is attacked by the States, then the catastrophe now called Iraq will spread through the Middle East? The States could find itself facing the aggressive nations of Islam on a broad front, giving the US a clandestine but suicidal enemy far greater than the small numbers of Al Qaeda and more difficult to counter.

   Measured on a risk-reward basis, such a war would rank as a speculative high-risk investment, promising poor returns.

China failing to export oil

   Turning to the other ‘tributary’ problems in the oil market, we see China is officially discouraging the export of strategically important commodities. Such a policy makes sound economic sense, but it will reduce supply to the world markets, pushing prices up still further.

   As an example of government control in China, the country's crude oil exports fell to zero in Feb. on the back of falling crude prices plus a new export tax imposed on energy-related products. In the first two months of the year, crude exports fell 31.1% to 300,000 tonnes.

   Meanwhile, China continues a policy of ignoring the politics of its suppliers, simply securing future supplies through generous gifts of infrastructural development. The policy is paying off as emerging nations welcome the disappearance of aid-tied interference. It gives them a new boldness on the global stage – plus an acceptance of their bad behavior.

   This has to tighten the "marginal supplies" in time, and it's those marginal supplies that set prices for the markets. Consequently the pressure on oil supplies will increase and makes nations like Iran more powerful on the oil front.

   As this problem tributary joins the pressures on the US consumer so the prospect of the double whammy – US consumers plus China – gains velocity.

Iran now paid in Euros for oil

   Perhaps the one tributary factor that will break the Dollar quicker than any other is the lessening of the use of the Dollar in the oil market. With the Euro on the rise as a global reserve currency – and the overhang of US Dollars growing with the rise of its competitor –any direct move away from the Dollar will weaken support for the already tenuous US currency.

   For some time now, Iran has been asking its customers to pay for oil in currencies other than the Dollar. Some sixty per cent of its crude income is now in other currencies. Hojjatollah Ghanimifard, international affairs director of the state-owned National Iranian Oil Company (NIOC), says almost all of Iran's European clients and some of its Asian customers have now accepted making payments in non-$ currencies.

   Whilst saying that the reasons are because of the weak $, clearly political strategy demanded such a change. The potential threat and present sanctions against Iran precipitated this change, but it now sets a successful pattern for other nations to follow. As they see the transition succeed and the $ retain the bulk of its strength, so we expect them to follow.

   Iran is expected to earn more than $50 billion from its energy exports in the Iranian year that ended on March 20th. Or is that now €37.50 million?

   This troublesome tributary could add the greatest force to the problematic oil market river in days to come. Russia is promoting Ruble payments over the Dollar already. Other nations will follow suit to secure the largest quantities of oil, using the foreign exchanges to switch from their Dollar reserves to the Euro to make such payments, so chipping away at the Dollar’s strength.

   The total pressure so far from these three problems will prove more than the sum total as the three could easily overwhelm the market levees. When this happens is there any back-up to prevent an out-of-control oil market?

Is Iran vulnerable to a cut-off in refined petrol supplies?

   Confrontation with chests stuck out is the usual way to convince bystanders and protagonists of strength. An inkling of this was given in an interesting comment by the US Department of Energy. It reminded the market that Iran, while a significant exporter of crude oil, has inadequate refining capacity to meet its domestic refined fuel needs.

   Any interruption in trade flows due to sanctions or hostilities would also interrupt gasoline imports into Iran as well as crude exports coming out. The DoE may be pointing out that an interruption in energy flows would also deprive Iran of refined product.

   Is this a potential threat from Western refineries?

   With Iran’s growing oil relationship with China it is most likely that China will supply Iran refined oil and petroleum. It may take time but we expect it has been proposed already. For China the benefit would be to get a valuable long-term supply of crude out of US hands. Such threats from the US will backfire on Washington.

   Emerging nations are finding in China a docile yet willing buyer of oil. For example, President Hugo Chavez of Venezuela has said China is set to rival the United States as Venezuela's top oil buyer. He recently announced new plans with the third major world economy to jointly ship oil, build refineries, and expand crude production.

   Chavez, speaking after meeting with an official from the state-owned China National Petroleum Corp., told reporters that, "As a power, the United States is going down, while China is moving up."

   Chavez said Venezuela was on track to reach its goal of raising oil sales to China to 1 million barrels a day by 2012 from its current level of about 150,000 barrels a day.

   "When we begin speaking of 1 million barrels of crude, we're nearing the level of Venezuelan supplies to the United States," Chavez said. Venezuela currently ships about 1.5 million barrels a day to the United States.

   "We do not deny what a big market the United States is – one we have maintained and are resolved and interested in maintaining, as well as our refineries there and our great company, Citgo [Petroleum Corp.]," he said. "But now Venezuela is diversifying."

   Chavez announced plans for Venezuela and China to build three refineries in China that will process a total of 800,000 barrels a day of heavy Venezuelan crude. "In two years these refineries should be built and ready."

   The Venezuelan president also said the two countries decided to start a joint oil shipping company with its own tankers to carry crude and other products between Venezuela and China, as well as to other world markets. Venezuela will also allow China to expand its oil exploration activities in the Orinoco River region, Chavez said.

   "[These agreements] place us without doubt as one of [China's] most important partners, I think, not just on the continent but in the world."

   Now add the joker in the pack – the weather worries. A consequence of global warming, they're forecast to produce many very serious storms and hurricanes from June onwards. If just one of these hurricanes hits Houston, then the trump card will have been played and the balance of oil demand and supply will tip, adding not just pricing force to the oil market, but political confrontation across the world as the grab will be on for available supplies. The chances of the US consumer continuing to drive US growth drop and the prospect of a recession move from debate to certainty

   So when these separate problems join together, far more than just a higher oil price is at stake, much more. When the flooding occurs in this river, high ground will be gold and silver.

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JULIAN PHILLIPS – one half of the highly respected team at – began his career in the financial markets back in 1970, when he left the British Army after serving as an Officer in the Light Infantry in Malaya, Mauritius, and Belfast.

First he worked in Timber Management and then joined the London Stock Exchange, qualifying as a member and specializing from the beginning in currencies, gold and the "Dollar Premium". On moving to South Africa, Julian was appointed a macro-economist for the Electricity Supply Commission – guiding currency decisions on the multi-billion foreign Loan Portfolio – before joining Chase Manhattan and the UK Merchant Bank, Hill Samuel, in Johannesburg.

There he specialized in gold, before moving to Capetown, where he established the Fund Management department of the Board of Executors. Julian returned to the "Gold World" over two years ago, contributing his exceptional experience and insights to Global Watch: The Gold Forecaster.

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