Countdown To Energy War

The conflict with Iran over their advancing nuclear program has moved gradually toward severe escalation. Iran's insistence to develop uranium enrichment facilities creates a supply fork. One tine extends legitimately to their electrical generating plants powered by enriched uranium. Another tine extends to a nuclear weapon arsenal, potentially. Russia has assured the West of its primary role to handle spent fuel, the key ingredient for weapon grade material. If the conflict ignites, expect a sudden $10 jump in the crude oil price, maybe even a $30 jump. Iran commands more control over the critical Strait of Hormutz than any other Persian Gulf nation, as Chinese Silkworm missiles are deployed in strategic emplacements. The energy war has numerous skirmishes afoot. However, Iran serves as the focal point for the detonation device on that war. Above board, the United Nations will be involved. Under the table, the Israeli military will be involved. Actual military action could close the Hormuz Straits controlling the Persian Gulf, where a large portion of world oil supply exits.

ALL THESE BATTLES ENSURE A PERMANENT ENERGY BULL MARKET GEOPOLITICAL CONFLICT ENSURES A PERMANENT GOLD BULL MARKET

And then there is Russia pulling rank over Ukraine, ending communist silly subsidies, which put Europe in the energy shadows. There is more than this story. And then there is Nigeria, whose offshore natural gasfields have been bid for by China and accepted. The West lost this one. And then there is Kazakhstan, which also has been secured by China. So much for the failed Unocal bid. The West might be in the process of losing the entire Caspian region. China has responded by focusing upon Central Asia, locking it down and thumbing their noses at North America. The lesson learned is that China has been given a message "Your money is no good, even though it is US$-based!" And then there is Iraq. The cost of the war might be far higher than originally believed, like near $2000 billion. Worse, religious and sectarian battles might fracture the union, from either Shiite divisions with Sunnis, or else from Kurdish insistence on independence as seen with reluctance to share oil revenues.

The bidding wars have begun. The opening of the Iranian Oil Exchange has, in my view, prompted a massive propaganda campaign by the USGovt to muddy the waters. The US Military might not be capable to attack Iran directly, since Russia has promised military retaliation if foreign aggressors attack Iran. The more we see the United Nations dragged into the fray, the more you can be certain the USGovt feels powerless to face off Iran. The entire nuclear power, uranium enrichment, and proliferation arguments seem absurdly exaggerated. Putin has promised to handle all Iranian reprocessing of spent uranium, you know, the stuff that becomes weapons grade fuel. The timing next to the March launch of the Iranian Oil Exchange, with planned sales of crude oil and natural gas in euro denomination, seems suspicious. Sale of oil in euro currency represents such a grand threat to the Petro-Dollar superstructure system, that one must wonder if the financial challenge to the US$-centric world is construed as an assault worthy of military response. Count me as precisely one such observer. The importance of Saddam's sale of oil in euro terms is vastly under-appreciated, under-reported, and under-estimated.

THE GLOBAL PICTURE OF CONFLICT
A global energy war has begun, which will involve oil as its center and conflict over it both regionally and globally. The war will forge two-way and three-way partnerships. In the course of securing relationships built upon sales & supply contracts, large construction, production, and exploration contracts will guarantee and lock up the sale of output as a reward. Enormous capital requirements are outlined. Furthermore, risks abound, as some new prospective energy properties might contain large risks on cost assessment and time estimations. The extreme risk is for the USA to be locked out of all new marginal supply from East Asia to West Asia as far as to West Africa, and even to lose some of the current supply reaching the market. Over the course of the next two years, a global battle will surely erupt to secure the energy deposits, and to control shipping lanes. It will be a miracle if military conflict is averted in the battle for progressively more scarce energy supplies. In 2006, the severity and seriousness of the conflict will come front & center to the geopolitical stage.

It is the marginal newer discoveries which will be the immediate battleground, free from existing contracts. Big investment is needed for many scheduled projects. Much will be needed to build liquefied natural gas (LNG) port facilities and virgin territorial development. With the Iraqi War the USA is distracted from securing any new supply beyond the traditional sources such as the Persian Gulf region. Piece by piece, the United States and European corporations are being either excluded (for political reasons) or losing out from negotiations. Some producing nations perceive a heavy political price, complete with a degree of subservience, for working with American corporations. The USA is not making the planned inroads in the entire Caspian region of former Soviet republics, nor in Iran. The USA might squander control of Afghanistan, with no benefit in the control of any nearby pipeline.

Iran is the clear pipeline winner in the Caspian region. Thus the propaganda against Iran in the news media. The United States will not control the Iranian oil pipeline, nor will Europe. Heck, nor will Russia, but Russia will be much better positioned than the West. By reporting the chants against Israel by newly elected Iranian leaders, and not reporting the bombing by Israeli black bag agents of Iran's largest oil facility last June 2005, the press has presented a bias. My purpose is to avoid politics and its assured controversy. My view is that Iranian leaders relish in whipping up crowds much like a high school pep rally, perhaps to divert attention away from the mullah corruption and prevalent poverty. My view is that the USA is boxed in, unable to challenge Iran directly, since Russia has promised military retaliation is aggression is taken against Iran. So the United States appears to have enlisted secretive (and surely effective) Israeli assistance. Make your own minds up on truth in reporting. My experience over the last three years has uncovered numerous salacious, exciting, and gripping stories which never make it to the US press & media, for some reason. My suspicions put forth many possible motives for news suppression. Control of public opinion is foremost among them.

RUSSIA & UKRAINE END SOVIET SUBSIDIES
The battle royal between Russia and Ukraine has many components. Almost nothing is properly reported in the lapdog US press & media. The skirmish extends the breakup of the Soviet Union empire, attempts to dissolve the old absurdly cheap subsidies to the Soviet Republics, while at the same time granting some legitimate revenue to producing former republics without the drag stench of heavy subsidized discounts. Such is the bilateral battle, whose additional motive is revenge for displacing the corrupt winner in summer 2004 of the Putin favorite, as populist leader Viktor Yushchenko was finally elected Ukrainian president. The re-election installation of the popular leader enraged Putin, who chose now as his time for revenge. Ukrainian leaders accuse Russia of attacking their economy in revenge for Ukrainian attempts to foster warm relations with the west. The hidden motive might be for Russia to enlist Europe, not without a risk of lost confidence in reliable supply, to engage Iran so that China does not solidify a lock with Iran instead. Russia and Iran collectively possess something like 35% to 40% of known global gas reserves (Russia 25% to 30% with Iran another 10%), which places these nations in a staggering dominant position globally. Some European countries get upwards of 50% of their gas from the Russian Bear. Putin wants Europe to get involved, and not be locked out like the diplomatically clumsy Americans. The Kremlin has driven a wedge not only between the Europeans and the Ukrainians, but between the Europeans and the Americans. Price of natural gas is the chosen weapon. Gazprom wanted a four-fold price rise, an end to imperial communist subsidies, but settled for a doubling in price with a beneficial provision for Russian-based supply. Ukraine agrees in principle to an increase in cost, but wants it phased in over time.

The populist "Orange Revolution" in Ukraine has put a coffin nail in the old empire, now to be seen as broken, whose fragments seek stability. With the Gazprom squabble, Yushchenko looks weak enough to lose political ground in upcoming parliamentary March elections. Legal warfare secured Yukos into the grand Russian state of owned energy monopolies, which includes Gazprom and whose strategic value is now utterly crystal clear. From its dominant lord position, Putin ordered a quadruple in the natural gas price to Ukraine, putting an end to Soviet-style subsidies. Why bother, if the renegade republic overrides the corrupted election, enforces democratic choices, and warms to Europe and the West? The price had been $50 per 1000 cubic meters ($1.42 per 1000 cuft), an absurdly low price not really emphasized in US press reports. Gazprom wanted $230 per 1000 cum, and settled for $95 per kcum. Even the desired higher price is only $6.55 per kcuft, well below the $9 to $10 market price, still a discount. Moscow and Kiev settled the matter by agreeing to a compromise five year contract. Under terms of that deal, natural gas from the Central Asian states of Turkmenistan, Uzbekistan and Kazakhstan will be transported through Russia, making up a mix that would supply Ukraine at a rate of $95 per 1000 cubic meters. Any Russian gas fed into that mix will be sold at the full Gazprom rate of $230. The Central Asians, who previously were restricted to sell natural gas only to the heavily subsidized Russian market, now have gained a significant export market for their supplies. However, it comes at a political price to Europeans, since Central Asian output flows through Russia before reaching Ukraine. Thus, Europe has been drawn into regional politics.

The Ukrainian state gas and oil company Naftogaz saw fit to divert significant natural gas flows intended for Europe, which also depends heavily on Russian natural gas. A whopping 80% of those supplies cross Ukraine, so that the Russian cutoff hurt Europe rather than Kiev. Moscow accused the country of stealing $25 million worth of Russian natural gas destined for other countries. The Gazprom deputy chairman Alexander Medvedev accused Ukraine of siphoning off 100 million cubic meters of gas as it was directed through Ukraine on its way to other European destinations. The dispute resulting in Gazprom shutting off flows to Ukraine, but continuing in reduced shipments to Eastern Europe. Each of Slovakia, Hungary, Poland, and Austria reported up to 40% shortfalls in their oil supply from Russia. Supplies of Russian gas to Italy fell by 25%, according to Eni. Deliveries of Russian gas to France dropped up to 30%, according to Gaz de France. Moldovan reported its fuel supply also cut off.

From the beginning, the natural gas spat has been about much more than financial in annual energy sales. This squabble is over the orientation of Ukraine between West and East, and ultimately over the ability of Russia to regenerate its geopolitical fortunes. Moscow could not reliably exert control over Belarus either, since its primary water transport route, the Dnieper River, flows south to Ukraine. Besides, Belarus is nearly as well linked into Poland and the Baltics as it is to Russia itself. Furthermore, the Ukraine port of Sevastopol on the Black Sea has long been the only deep, warm-water port available to Russia. This conflict is more about control and power than money. Dmitry Medvedev is first deputy prime minister to Russia, a Putin protégé and (not coincidentally) the board chairman of Gazprom. The Ukraine natural gas crisis is his first Russian foreignpolicy initiative.

The geopolitical energy struggle has caught Europe in the Gazprom crossfire. The 25-year cold war between the United States and Iran has pushed Iran into a mutually beneficial commercial relationship with China. The US lacks diplomatic skill to the point that it has put the West at great risk. The Iraqi War is not only a sink for over $1000 billion in costs, but also a grand diplomatic cost. Putin is a master chess player. The many pipeline battles, with Turkey and Chechnya fought over, have placed Iran in central importance. Caspian republics are aligned with Iran. Enormous oil & gas supplies are being secured by China. If Europe aligns with the USA, they will be locked out. If they align with Russia, they will enjoy the bounty of Iranian energy supplies. Will Iran work closely with Europe or China? … that is the question.

KAZAKHSTAN SELLS TO CHINA
Last month the state owned China National Petroleum Corp (CNPC) launched an oil pipeline running from Kazakhstan to northwest China. That pipeline will sidestep the geopolitical significance of the Baku-Tbilisi-Ceyhan oil pipeline backed by the United States, which opened this past summer amid big fanfare. The geopolitical chess game for the control of the energy flows of Central Asia spanning from the Atlantic to the China Sea is sharply evident in the latest developments. The politically charged angle comes from China considering a formal request to Russian companies to help it fill the pipeline with oil, until Kazakh supply is sufficient. An arc of influence built upon US military bases across former Soviet republics might be averted by such a Kazakh-China oil pipeline. The USGovt has targeted the region for democratic reform in order to facilitate energy contracts. The Kashagan in Kazakhstan is the largest new oil discovery in decades, greater in scope than the North Sea deposit. The republic has no ports, and oversees at least 35 billion barrels of oil reserves, perhaps 100 billion barrels. Their landlocked status urges a solution to secure pipelines and routes to the shipping seas. These events come after China completed a $4.18 billion takeover of PetroKazakhstan in recent months, another failure by the USGovt on the diplomatic and energy geopolitical arena.

Initially, half the oil pumped through the new 200k barrel per day pipeline is scheduled to come from Russia, as initial output ramps up from nearby Kazakh fields. The new China pipeline runs almost 1000 kilometers to take China a third of the way to Kashagan in the Caspian Sea. This is a major reason Washington has such a strong interest in supporting democratic regime change in the Central Asia region of late. In the next 10 years, Kazakhstan plans to almost triple oil production, prompting the landlocked nation to seek new export routes because the country wants to avoid pipelines through Russia and excessive Russian dependence. China is now among Kazakhstan's major target markets.

Best public estimates are that Kazakhstan has 35 billion barrels of discovered oil reserves, twice the amount in the North Sea, and may hold about three times more, according to a November Kazakh government report. German oil engineers have privately reported that recent drilling by Italy's AGIP, the current oil consortium leader for Kashagan, a huge field offshore Kazakhstan southwest of Tengiz, has confirmed enormous oil deposits there. Certain Caspian region deposits were downgraded in the last two years, much less than once thought. It seems Kazakhstan deposits are sizeable and very substantial.

Last October Beijing scored a second major geopolitical coup when China completed a $4.18 billion takeover of PetroKazakhstan Inc. It was undoubtedly sweet revenge against Washington for the blocking of the China acquisition of Unocal. US oil majors had made major efforts to lock up Kazakhstan oil after discovery of major oil offshore in the Kashagan field. They failed. One must wonder why the US continues to fail, and whether hegemony is real and resisted by the world. Perhaps the US exerts too much pressure for military cooperation, directly or implicitly. US laws sure don't help. Exxon Mobil was charged with bribery of Kazakh officials and a senior Mobil executive was later jailed on US tax evasion in New York tied to the Kazakh bribery payments.

DANCING WITH NIGERIA OFFSHORE
Time will tell whether OPEC might soon splinter on its outer non-Persian Gulf edges. Oil & Natural Gas Corp (ONGC), India's largest oil producer, has offered over $2 billion for a believed 45% stake in a Nigerian oil & gas field, a new sign of determination by Indian state owned energy companies to secure assets for the Indian booming economy. The Indian bid prevailed over the rival CNOOC offer, which failed to secure the Unocal deal last summer. The US Congress blocked the deal on national security concerns. China and India have emerged to work together in recent months, sure to keep down final contract prices. In December the two developing nations confirmed that China and India would bid jointly for a 38% stake in the Al Furat oil field in Syria, the first collaboration between the two giant economies in energy. India is Asia's fourth largest oil consumer. Ooops!! The Indian government blocked the deal on the grounds of commercially unviable. The Chinese National Offshore Oil Company stepped in to purchase the 45% stake for $2.27 billion. So India's loss is China's gain. Output is set for Western customers, not China, sure to relieve supply constraints.

The stake would be in the Akpo offshore field that is now owned by Nigeria's South Atlantic Petroleum Ltd. Scotland-based Wood Mackenzie estimated the Akpo recoverable reserves of light oil condensate at 620 million barrels, and natural gas at 2.5 trillion cubic feet. The field is expected to produce 225k barrels per day by Calgary-based Total Energy. In August, ONGC lost to Chinese rivals in bids for assets in Ecuador and Kazakhstan valued at a combined $5.6 billion. In August, India and China decided to jointly pursue such assets selectively. New Delhi hopes the arrangement will minimize the scope for competition between the two, which it says only ends up raising the acquisition price. But Indian officials have emphasized that the pact does not preclude their national oil companies from engaging in competitive bids against each other. CNOOC has won the Akpo property, which differs from past deals. The output is set for export to the United States and Europe, not to China. The position has been circulated that China might be motivated to relieve some Western constraints brought about by growing demand for energy from developing nations such as China & India.

Energy is crucial for India and its developing economy. With domestic oil production stagnating and consumption rising at about 7% a year, India imports more than 70% of its crude oil requirements. That strains the import bill at a time global prices are high. Indian officials say their goal is to minimize oil imports and to have "exclusive control" of at least 30% of its long-term requirements. India is "odd man out" in this Nigerian foray. One must wonder to what lengths nations will pursue energy assets. Royal Dutch Shell spent $1 billion in cost overruns over two extra years at the nearby Bonga deepwater oilfield. India saw red flags, so it seems. This cost overrun must have caught the attention of Indian leaders.

KURDISTAN WEALTH THREATENS IRAQI UNITY
Clashes over control of oil wealth has the potential of fracturing the uneasy fragile new parliamentary republic in Iraq. Newly defiant Kurdish (northeast province on Turkish border) leaders have seen fit to exploit their resource fortunes for the benefit of their people, at the risk of direct challenge to the upcoming Iraqi National Assembly. An exploration contract deal with the Norwegian energy firm DNO has taken the fledgling political leaders in Baghdad off balance. No formal approval has been granted. Other deals are in early stages. They fear a Kurdish maverick movement in their own local interest, to finance an independent state as part of an oil-led disintegration. Whether this Norwegian deal comes to fruition or not, the path has been laid for future deals. Iraq's neighbors have always harbored tensions and misgivings over a free Kurdish state. Roughly 20 million disenfranchised Kurds live in Turkey, Iran, and Syria, never to have enjoyed any sovereignty or self-interested power. Calling them home to a newly formed nation is the fear. Oil wealth could pave the path to a newborn nation. The potential exists for a fracture of Iraq. If religious sectarian conflict does not divide this unstable and war-torn nation, inequitable division of oil wealth might more clearly. Nothing much in life eclipses the importance to control either religious practice or wealth distribution.

The Kurds, long slighted and often having suffered in the past Iraqi dictatorship, have decided to flex their muscles and forge new contract relationships. It could be that Kurdish leaders see a ripe "payback" opportunity, motivated by a desire to remedy past crimes and deprivation which included incidents of genocide. The Iraq draft constitution was approved in an Oct 15th referendum. It stipulates vaguely that "the federal government with the producing regional and governorate governments shall together formulate [energy policy]." It makes ambiguous reference to providing compensation for "damaged regions that were unjustly deprived by the former regime" who were the aggrieved victims of crime and neglect. Kurdish leaders concede the sharing of existing production wealth. It is future oil discoveries that they wish to control and keep for their own regional development. The defiance is vivid in the words of Barzani. "The time has come that instead of suffering, the people of Kurdistan will benefit from the fortunes and resources of their country." Note the reference to the region, which they crave as a nation. This was a constant obstacle in the painstaking constitutional negotiations. Kurds wants the power to make deals and control new revenue. Sunnis consistently voted against it. Such is the stuff of civil war. Makki, leader of the Iraqi Islamic Party, a Sunni Arab group, summed it up well. "This is unprecedented. It is like they are an independent country. This is Iraqi oil and should be shared with all the Iraqi partners." Counsel to Prime Minister Jafari said "We need to figure out if this is allowed in the constitution." Expect them battle as they learn.

My view is that the Kurdistan province will exploit its riches and oppose the oil-poor central region dominated by the Sunnis. Sharing oil wealth is most certainly not a high priority to Kurds, long oppressed. In the factional struggle, oil will not lubricate, but rather fracture the embryonic republic. The complexity of Iraq and its sects is mindboggling. They have Shiite domination in south near the city of Basra, where enormous oil wealth has been a fixture for decades. A key port operates there, on the Persian Gulf. In the region around the capital Baghdad, Sunni and secular (non-religious) groups possess nearly nothing in oil wealth. For decades, the Kurds to the north and the Shiites to the south have regarded the controlling dictator operating out of the central region to be parasitic, violent, and evil with just cause. No reports have come out of Basra for secession and creation of an independent state. However, such is a vivid dangerous reality in Kurd, which wants its sovereign nation of Kurdistan, nourished by oil wealth. Iraq will not be cemented into a strong union without numerous challenges, replete with calls for restitution for past crimes and neglect. The nation will rather be splintered rather easily along lines of religious differences to control lifestyle, and according to greedy self-interest to retain oil wealth.

BACK TO THE ENERGY BUSINESS
On the business side, the commercial reality, two phenomena strike the casual observer as important. In Alberta, property prices have shot up by triple since 2001. So not only are energy firms forced to endure higher diesel costs, and more arduous operational challenges from the northward move of the frozen tundra muskeg, but property acquisitions are escalating in cost. That smacks of irony, that energy firms are being hurt by high energy costs, on top of higher prices for energy property. They are somewhat victims of their own success. It only means that energy prices must go MUCH HIGHER in order to bring more supply to market, in order to meet the growing demand. Don't be deterred by unusually mild winter weather in the northern USA. My view is that the energy bull market is permanent.

In the Persian Gulf, grand expansion of port facilities continues. The Ras Laffan Industrial City in Qatar, when completed, will be the world's largest single source of liquified natural gas. However, a glut might be on the horizon for LNG vessels. Shipyards have orders for 126 carriers, enough to contain and transport 692 million cuft of natgas. The current world fleet of 184 carriers can move 770 mcuft. Profits measured by annual returns for crude oil measure 12% to 13%, much higher than the measly 3% to 5% returns available to LNG shippers.

Expect the entire world to be turned upside down in the year 2006. The United States continues to fight to recover from a trio of devastating hurricanes. The Gulf Coast energy producers report that 2 billion cuft per day of natgas output remains offline, and 400 thousand barrels per day of crude oil output remains offline. Central Asia has done battle over construction of oil pipelines, even as its flow is contracted for purchase. The edge of OPEC, such as Nigeria and perhaps later Mexico, might sell their output or their marginal supply to specific nations. Political alliance might very soon become far more important for securing energy supplies generally. Those nations with poor diplomatic ties and counter-productive initiatives might soon find themselves "outside looking in" like with Iran.

The big theme in my view for the new year will become taking energy source by source OFF THE MARKET as one location after another is secured through contract. The real battle is over new marginal supply from the newest deposits. Watch the passageways, the straits, the shipping lanes, the pipelines. Iran defends the Persian Gulf effectively. Other straits like near Indonesia are also important. The year 2006 is off with a bang, from Russia strongarming Ukraine and Europe, and from Iran defying the West. One might conclude that Russia is attempting, with minimal actual damage and disruption, to enlist European leaders to join the commercial contract process for gigantic Iranian energy supplies. Putin might want Europe to ignore unproductive political positions put forth by the USGovt and its leaders, who seem to have failed on the diplomatic front. Putin might want the West (Europe and United States) to GRAB THE IRANIAN NATGAS PRODUCTION, SO THAT CHINA DOES NOT SECURE IT FIRST. China is grabbing every loose energy deposit at the margin table.

The United States is totally preoccupied with Iraq and Iran. Is Iraqi oil output lower than before the war began in March 2003? The USA is not winning the energy war. We are far too concerned about the lifestyle of caribou and moose and polar bears, and far too little concerned about people, their homes and industrial sites. Progress for both development of Alaskan pipelines and oil discovery are woeful, if not embarrassing. Priorities might require a vast rework in 2006. The war slogan of "Freedom Isn't Free" should perhaps be replaced by "Energy Isn't Cheap" in my humble opinion, but then again, just a jackass talking.

THE HAT TRICK LETTER COMBINES MACRO ANALYSIS WITH INVESTMENTS.

THE HAT TRICK LETTER COMBINES MACRO ANALYSIS WITH INVESTMENTS. From subscribers and readers:
"Please don't change your style because a few people do not have the required attention span for anything more then comic books. I like my JW straight up, not watered down for mass consumption."
    (Joel P in Quebec)
"As an aside, I've been managing money for 15 years and have met a number of top minds from Wall Street and I can say that I consider your work exceptional. You've got a terrific way of knitting seemingly unrelated pieces of information into a clear, concise view of the big picture."
    (Philip B in New York)
"Jim has a way of cutting through all the fluff and getting right at the heart of things but doing so in a manner that is both easy to understand and fun to read. His work is both original and provocative, and he is one of the few guys out there that I look forward to reading."
    (Dan Norcini, commodity trader, NOT a subscriber)
"I just read your latest piece about the yield curve. You are right on the money with pretty much everything you say, as usual. Also, those are good insights [on why the XAU index has jumped before the HUI]."
    (Alex Wallenwein, currency analyst, NOT a subscriber)

Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 24 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com. For personal questions about subscriptions, contact him at [email protected]