The Secret History of Oil and Money - Part 4

Last time we saw that a series of events had managed to move the power from the oil companies to the oil producing states via OPEC. They used that power first to get an increase in the price in 1970, and then increase it again and add an embargo in 1973. We also saw that in 1971, the amount of Eurodollars floating around caused the U.S. to sever the ties to gold and let currencies float. This meant that there was no limit on the money that could be printed to pay for the oil. The problem was that the money represented real claims against the West. With the increase in price, there was no way the West could sell anything to these essentially undeveloped countries to balance out the money they had to pay to get the oil.

The owners of the oil, everywhere in the world, were four times as rich after Tehran; soon they would be ten times as rich. 

The West Germans, the thrifty, hard-working West Germans, had gone to the office and the factory, and hammered and blowtorched and bolted, and they had infested the world with their Beetle Volkswagens, their machinery, and their chemicals, and they had earned, by 1975, a surplus of $40 billion.  

And the Japanese, with their beehive cooperation, had gone to the factory early in the morning and sung "Hail to Thee, O Matsushita," the company song, and done their group calisthenics, and hammered and buzzed around and swamped the world in television sets and stereos and cameras and little cars, and after years of work they were on their way to multibillion-dollar surpluses.  

The United States and Britain and Italy didn't have any such surpluses at all (though the United States did have the long-term investments from its key-currency heyday). And now, suddenly, one country—one family—had an exchange surplus of $60 billion! Without even working!

While sitting in a gas line, Smith ponders the question asked by the Hungarian banker - if the price of oil had quadrupled, where do we get the money to pay for the oil that we need?

First I thought, This gas line is burning up a lot of gas just trying to get more. Then: How do we pay for the oil quadruple? That is, we, the United States? Well, we could sell something to the Arabs. What are we good at growing or making and selling? Aircraft, wheat, soybeans, maybe some high-technology equipment. Now, what are they buying? Who's in OPEC? We can forget Gabon and Ecuador and Qatar—not significant. Who are we talking about? Iraq: cross off, no relations with them. Libya, Kuwait, Saudi Arabia, Iran. Libya: fewer than 2 million people. Kuwait: fewer than 300,000. Saudi Arabia: 6 million. Small countries. Don't have big airlines. Sell a couple of 727s, a 747 or two; that's about enough oil for ten minutes of gas lines. Wheat, soybeans—small countries don't eat much; we have 120 million cars, each car is sitting in a gas line with its motor running; you could sell all the wheat and soybeans Libya, Kuwait, and Saudi Arabia could eat and only move the whole national gas line one block. Less. Maybe thirty feet. Of course, Iran ... 33 million people. Shah—aircraft? A couple more airplanes, a little more wheat—aircraft, arms. We could sell arms to the Shah. 

But not enough to the other folks. No, what we will buy the oil with is dollars, because the world takes dollars, trades in dollars. And the oil folk will have the dollars, and then they can come and buy what they want. But nobody realizes the scale. Let's just say we pay the import price for half of the oil needs, at let's say, $10 a barrel, carry the 3, times 365 days in the year; my goodness, in one year OPEC could have $100 billion extra, maybe $200 billion soon, then they could come and buy half of the stocks on the New York Stock Exchange, almost half. And that's only one year. The next year the 120 million cars are back at the gas pump, and OPEC has another $100 billion, and they keep piling up those claim checks until they can buy the whole New York Stock Exchange. They keep the claim check, and we move the cars around. We are going to sell America for a product that burns up in the atmosphere. We will be a colony...

The triumph of the Club is something quite unparalleled in history. When else was there such a transfer of wealth? When the Spaniards brought back the gold and silver of Peru? When the British raj (sic) ruled India?

Smith discusses a rumor that Nixon actually wanted the price of oil to go up. Why? To arm the Shah of Iran and keep the Middle East in balance.

Nixon and Kissinger stopped off in Iran on the way home from the Moscow summit in 1972. What they saw was a dangerous situation. The British had withdrawn from the Persian Gulf at the end of 1971; the United States was still involved in Vietnam. There was a power vacuum in the strategic Middle East. The Shah could take it over and would get the arms to do so.  

How would the Shah pay for the arms? By raising the price of oil. No American Congress would have voted billions to arm Iran, it was thought, while troops were still in Vietnam. James Akins reported that the Saudis were worried both by the Iranian buildup and by the prospect of a high price for oil, which they thought would damage the stability of the West, on which their bank accounts and survival depended.

Smith ultimately discards the theory:

If a quadrupled oil price was the cost of arming the Shah, it was one of the most expensive blunders in history. The scale of the transfer of wealth is hard to comprehend, and in this instance the arithmetic makes no sense. If $90 billion a year sounds silly divided into orange juice, it does not make much more sense divided into F-14s...the West could transfer to OPEC one air force, one navy, and still owe $100 billion every year.

The Western industrial economies now had the worst of both inflation and recession. Normally inflation is caused by an overheating economy, not one where people are worried about their jobs and how to pay for things.

The higher oil prices acted as a fiscal drag, a tax. Higher prices for oil meant higher prices for fertilizer and plastics as well as gasoline and heat. If your gasoline bill and your heating bill and your food bill went up, you might defer buying a car; then the automobile manufacturer laid off  some workers, who in turn cut back on their own purchases. The recession of 1974-75 was the worst since the Depression of the 1930s.
And at that same time, inflation went up sharply. In the United States direct and indirect energy costs amount to 10 percent of pretax household income. A 100-percent rise in energy costs meant 10-percent inflation, all by itself. Not all the energy was oil, and not all oil came from the Middle East; but the price of OPEC oil had just gone up 400 percent, and the OPEC price became the world price.

In those days, unions still had power. As gas prices rose, unions demanded wage increases to compensate. Workers did not want to take the hit to their disposable incomes just to get to work. Employers granted the wage concessions, but raised prices to protect profits. This increase in prices caused the unions to once again demand higher wages and so on. A feedback loop was created, sometimes called a wage-price spiral. 

Unions were unafraid to go on strike when their demands were not met, leading to disruption of everyday life. The garbagemen went on strike in New York city causing garbage to pile up and fester in '68, '74 and '81. Coal miners went on strike in England, crippling the economy and leading to the introduction of rationing and a three-day workweek in 1974. This led to the changing attitudes toward unions during this period. Unions, once seen as stalwart defenders of the Middle Class, were seen as causing major inconveniences to the public, and the public mood turned against them. Corporations saw this as an opportunity and unleashed a relentless barrage of anti-union propaganda, playing up their ties to organized crime and depictingthem as corrupt anachronisms that defended lazy workers.

A series of radical energy conservation measures were adopted. Vehicle fuel economy standards were raised. Building efficiency standards were raised; insulation was mandatory. Travel went back to necessity only. The Strategic Petroleum Reserve was created, as was the International Energy Agency (IEA). Government studies looked at energy conservation measures and renewable energy. The speed limit was lowered to 55 MPH and Daylight Saving Time was introduced. For the first time ever, demand for oil fell. The oil usage in 1973 would not be seen again for a decade.

Americans did their part too. Solar "cheese wedge" houses spring up and people turned to the Whole Earth Catalog. The first commercial photovoltaic sells were sold and people experimented with wind energy. American consumers bought small fuel-efficient Japanese cars instead of American gas-guzzlers (the Japanese had no oil reserves and thus had to be efficient). This began the decline of the American automobile industry.

America was dealing with the energy crisis, but it was about to get a whole lot worse. In 1979, the Shah of Iran fell in a revolution led by the religious leader Ayatollah Khomeini. Iran became a theocracy hostile to the West. The American embassy staff was held hostage. Iranian oil production fell from 6 million barrels to 1.2 million barrels, a loss of 4.8 million barrels.

But the loss of oil was not the major problem - the problem was the wave of speculation on the markets caused by the unexpected loss that drove up the price of oil. Normally, oil is traded in a complex series of futures contracts. But there is also something called the spot market. Prices are settle in cash on the spot based on current values as opposed to forward prices, and delivery is expected within a month (Investopedia). In other words, it is immediate oil for short term needs. And by 1979, there were no cusions anymore, so the spot market became the go-to source.

As more and more countries went to the spot market to get oil, speculation drove the price up. The fear of further disruption spurred widespread speculative hoarding. Seeing the higher prices offered, oil sellers went to the spot market to sell in order to take advantage of the higher prices. To deal with this, OPEC raised the price of oil to the spot market price, causing another price shock.

Until the Shah fell, there was a modest surplus of oil in the channels of the world. Higher prices had forced some cutback in demand, and there was additional oil from Alaska and the North Sea. OPEC watchers noted that the cartel was getting less real money, because the Western currencies were depreciating faster than the oil price was going up.

But Iran was among the large producers, at 6 million barrels a day, and when the Shah was deposed, production from Iran's oil fields dropped to a fraction of the previous totals. That missing 6 million barrels a day was enough to create a shortage again, and the scramble resumed.

In the oil trade the "spot" market is called "Rotterdam," because oil can be bought, on a daily basis, from the huge tankers anchored in the Rotterdam harbor. The "Rotterdam" market, though, is all over the world. It is really the Telex through which the trades are made...The Iranian shutdown had made supplies tight. The Israelis and the South Africans could no longer buy Iranian oil, and they were looking for oil wherever they could find it. The Italians had only two weeks' worth of supply in the tanks, and the Spaniards and the Swedes were also low.

The new Iranian regime, with no loyalty to the old contracts with the Seven Sisters, began to sell to the "spot" market. On Monday, May 14, 1979, the Iranians sold oil at $23 a barrel, above the posted OPEC price of $13.34. On Tuesday it was $28. On Thursday it was $34. Ironically, the Seven Sisters were among the bidders; a subsidiary of Texaco secretly made a deal for 2 million barrels at $32. At Kharg Island in the Persian Gulf, there was the usual long line of tankers waiting to take on Iranian oil. The tankers with long-term contracts were told to stay anchored. (They were paying, incidentally, $35,000 a day in parking fees.) The tankers with "spot" contracts went right to the head of the line.

Not surprisingly, the "spot" market began to attract the oil. American oil companies with refined oil in the Caribbean began sending it to the "spot" market, seeking to maximize profits. The price in the "spot" market went as high as $42 a barrel.

Other OPEC nations pulled some oil from long-term contracts and sold it in the "spot" market. Some of the OPEC nations saw the dangers. OPEC was losing control! Libya and Algeria broke the $23.50-a-barrel ceiling set by the cartel. "Prices are out of control," warned Ali Khalifa al-Sabah, the oil minister of Kuwait. OPEC was breaking apart, but on the up side. No one had thought of that.

At the Department of Energy in Washington, officials totted up supply and demand. There should have been an excess of a million barrels a day, so why were prices going up?" The spot price reflects uncertainty, not shortage," said one analyst there.

The First Oil Crisis, in 1973-74, took oil from $2.69 to $11.65 a barrel, about a quadruple. The Second Oil Crisis, following the arrival of the Ayatollah Khomeini, produced roughly a double, to about $28 a barrel in 1979.

The Club was keeping up the game that worked so well: Leapfrog. Cut back the production, and supplies will be tight. Cut back the deliveries, and the oil consumers who can't get oil will go to the "spot" market, which is relatively small compared to the volume of world oil. The price in the "spot" market pops up. Then you say, well, that's the true value of oil, and you call a meeting of the oil ministers and move the OPEC price of oil up toward the "spot" market price. But if the "spot" market moves down again, you don't move the official price back down, because now you have a new long-term OPEC price. And you have room to do this because, taking OPEC as a whole, you need only 22 million of your 30 million barrels a day to pay your bills. The other 8 million barrels are "discretionary," and you can mess around with them, shut in some of them if necessary. Yet Leapfrog was not designed by OPEC ministers; they merely followed political events and took advantage.

Instead of Eurodollars, the world now had to worry about Petrodollars, since oil was denominated in dollars. Where would all those dollars go? They went into Western banks, by-and-large. But with the world in recession due to high oil prices, to whom could banks lend all that money to? Finding uses for all that money was termed Petrodollar recycling.

This problem is called Recycling the Petrodollars. The connection between the Sauds and the Rockefellers is that the Saud family puts its money in the Rockefeller family bank. Then the Rockefeller family bank lends the money around the world, sometimes to the people who need more money to pay the Saud family the new price of oil. Gertrude Stein said once that the money is always the money, only the pockets are different.
If the oil consumers could sell enough to the oil producers, the trade would come out even. If the Kenyans could raise the price of their coffee enough to pay for the increased price of gasoline and fertilizer, and the Saudis would drink enough coffee at the higher price to match that, no problem. But there aren't enough Saudis to drink that much coffee at any price. As we've seen, the oil producers who are "low absorbers" can't buy enough to make up for all the petrodollars they've suddenly earned.  

Ordinarily, oil should be a commodity like any other. But the current scale of the oil transfers, sent through the banks, creates more money.  

A higher price for oil sucks money out of an oil-consuming country. That country then has less money to spend for cars and apples and gasoline. Less money, less activity. recession, unemployment. Deflation—the oil price increase acts like a tax. In the oil-consuming country there is less money; in the oil producer there is more. So far it balances.  

Things being what they are, the tendency is for the oil consuming country to print a little more money to ease the pain of recession. That's politics, not economics or banking. Sending out real assets for the oil means very hard work. The central banker himself may want to tough it out, but the prime minister is already under attack by the labor unions and the parliament is restive.  

The oil producer still has the money paid for the oil, though, and doesn't need it. Into the bank it goes. Now the bank has a deposit, let's say, just to reverse all that OPEC gigantism, of $100. The Federal Reserve says that bank has to keep 10 percent deposit as a reserve. You walk in and borrow $90. You put that money in your checking account; now it's a deposit there, and your cousin Charley can walk in and borrow $81, because that fractional reserve is set aside each time. Your cousin Charley deposits his loan in his checking account, and the bank lends $72.90 to the next borrower. That's the way the multiplier works, and it keeps on going. If the Federal Reserve wants more money in the banks, it lowers that fractional reserve, so that you can borrow and your cousin Charley can borrow $85.50 instead 1. If the Federal Reserve wants there to be less money, it raises that fractional reserve.  

Question: What's the multiplier in Euroland? Theoretically, it's infinite. The Rockefeller bank of Euroland gets an OPEC deposit of $100, and it can lend the whole $100 to you; and when you deposit the $10U in the Deutsche Bank Luxembourg, that bank can lend the whole $100 to your cousin Charley, who puts it into the Banco d'Espagna of Euroland, and so on, so the original OPEC $100 gets quite a bit of mileage.
243-247

It turns out that what they did with the money was loan it out to Third-World Countries for development. That's right - the Third World Debt crisis you heard so much about a few years ago from the likes of Bono et alia had its origins in the massive influx of petrodollars into Western banks at a time of stagnant economies and high inflation:

Ironically, the struggle after 1979 to limit inflation by raising interest rates created a problem for the policy's instigators, the financial institutions, because it created a gulf between the amount money could earn if invested in a typical productive project and the rate of interest the entrepreneurs behind those projects were being asked to pay. Moreover, because the interest rate rise had produced a recession, very few of the institutions' domestic customers wanted to borrow anyway, except, as we have just seen, to pay their interest bills or to stave off collapse. The banks' problem of what to do with their funds was compounded because, as a result of the oil price rise, most OPEC countries had more money than they knew what to do with, having moved from having a small balance of payments deficit of $700 million in 1978 to a surplus of $100,000 million in 1980. Much of this money had been put in British and American banks on deposit.

To find a home for the OPEC cash as well as their own, bankers literally packed their suitcases and flew to the Third World. During a meeting of the Inter-American Development Bank in Madrid in 1981 senior bank officers queued up to offer funds to the man in charge of Mexico's borrowing as he lounged in an armchair at his hotel. A year later Mexico had borrowed so much that no-one was prepared to lend it more to repay old debts as they became due. It threatened to default, alerting the world the crisis the banks had created.

The bankers offered money to potential Third World borrowers at a price based on     based on the London interbank offered rate (LIBOR) plus 1 per cent. This meant that, if world interest rates increased, the rate of interest payable by the borrowing country did as well. It was a lazy man s way ot doing business because it made it impossible for borrowers to calculate the return they had to get from the projects for which they wanted the loans and the risk they were running by taking the loans on. However, the bankers thought their interests would be secure whatever happened to their borrowers' projects and rarely investigated them thoroughly. What mattered was that their profits in the  current year would be satisfactorily increased by the fixed margin they creamed off the top of the loan as a charge for agreeing to grant it. As for the future - well, as one banker, Walter Wriston, said at the time, countries don't go bankrupt, do they?

A factor that added to the banks' dangerous complacency was that they had done some Third World lending to recycle Middle Eastern funds after the 1973 oil price shock. These had generally worked out well, largely because the prices of the commodities exported by the borrowers had increased at an annual rate which exceeded the rate of interest being charged. In other words, there was no overall change in the relative wealth of borrower and lender throughout the period. The debt/export ratio had stayed constant and there was a net inflow of funds to most developing countries.

In the early 1980s, however, the deliberate contraction of demand in the United States and the EC caused commodity prices to plunge while the interest rates the producing countries had to pay were kept high, Consequently, rather than the wealth of both parties increasing in step, as had happened previously, money - or rather, claims on money - flowed from borrower to lender each year between 1981 and 1986 at a rate equivalent to interest at 20 per cent. As a debt doubles every 3.5 years at an interest rate of 20 per cent, the inevitable result was that these countries' ratio of debt to GNP tripled by 1987, although almost no new money was lent.

After the debt crisis became public in 1982 the value of the banks' Third World loans was gradually written down, involving them in showing huge losses. At the time of writing (1993), however, debtor countries have still not been released from their obligation to pay the full amount due, although some have been able to buy up some of their debt at a big discount on the secondary market where it was sold by smaller banks anxious to get cash for a very doubtful asset.

Richard Douthwaite; The Growth Illusion, pp. 67-68

Oil prices went up by a factor of ten in a decade. Right now the price of oil is about $45.00 a barrel, relatively cheap. Imagine looking at $450.00 a barrel oil in less than ten years and ask yourself what that would do. By 1981 unemployment was up over 10 percent and the economy was worse than at any time since the Great Depression. Unfortunately, it is here that Adam Smith's narrative stops.