2. Oil on Front Burner

The energy markets have their own singular approach to political developments.

DEBKA-Net-Weekly‘s oil sources report that the crude oil markets have thus far consistently discounted an overt war flaring with Iraq in the next six months.

Some experts maintain that crude oil prices contain a “war premium” of nearly $6 per barrel, with a low inventory premium of $3, which together lift the 10-year average crude price of $19 to the current market price of $28.

DEBKA-Net-Weekly’s oil experts would disagree, arguing that the war premium is minimal and that the better part of any such premium versus historical inventory to price correlations is attributable rather to low inventories and OPEC's decision to keep quotas unchanged at their last meeting in Osaka.

While cheating by the oil cartel is clearly on the rise, it is a purposeful action primarily led by the Saudis for the sake of keeping oil prices from spiking up and discouraging global economic growth and therefore the demand for energy.

That said, speculative money has largely been sidelined by the binomial nature of an approaching conflict in the oil-rich regions of the Middle East. A huge short interest would immediately build if the risk of war were to disappear entirely, while the fundamental undersupply might not manifest itself until the heart of winter. Thus, any news that diminishes the likelihood or proximity of conflict would depress oil prices.

Last week’s disclosure of North Korea’s nuclear weapons program caused a sell off of crude oil and a rally in the US equity markets, both prompted by the reflective assumption that the Bush Administration had lost its strongest justification for attacking Iraq.

That case appeared to rest on Iraq’s unique menace as a developer and confirmed user of weapons of mass destruction in defiance of UN prohibitions, and on Saddam's association with terrorist organizations. The recently murdered Abu Nidal was a long-time guest in Baghdad, al Qaeda operatives were found taking instruction in Iraq in the use of chemical and biological weapons, as well as its Afghan fugitives taking refuge in Baghdad. When his well documented record of extreme brutality is added to all this, the imperative for the United States and its allies to take immediate physical action to disarm him is legitimate.

Above all, America is seen as feeling impelled to act against the threat of uncontrollable WMD proliferation, which affords dictators the means to deliver deadly weapons against which no star wars system, missile shields or satellite lasers offers any protection. Out there too is a terrorist network capable of wielding the tools of free trade – aircraft, container ships, buses, trains – to strike at the heart of America.

But then came along the North Korean admission of its secret uranium enrichment capability which seriously undercut the Bush administration’s case for war against Iraq. It was faced with the dilemma of justifying an attack on Iraq while letting North Korea get away with diplomatic persuasion at the very moment that a seamless argument against Saddam Hussein was needed to bring the UN Security Council round to endorsing the newly drafted resolution.

The oil and equity markets said: “This throws a wrench into everything”.

Suddenly the administration was backtracking heavily, with conciliatory comments coming from both the moderate US secretary of state Colin Powell and the president’s national security adviser, Condoleezza Rice. Bush himself declared that military action was not his first but his last option.

Prices Drop as War Recedes

As war appeared to recede, oil prices fell. The implied volatilities on the crude oil futures markets, a measure similar to a risk premium on an insurance contract, are liable to contract in response to such news. In fact, the equity markets responded by rallying at first, not only under the stimulation of lowered oil prices, but also because military action appeared to be deferred until after Christmas and therefore after the seasonal American retail trade rush.

The revelation in this issue of DEBKA-Net-Weekly that Iran has achieved a nuclear device should have the same initial superficial response from the oil markets – a drop in crude prices driven by speculative holders anticipating a dramatically diminished probability of a US attack on Iraq. According to this line of reasoning, the US could scarcely justify an attack on Iraq, which is only potentially a rogue nuclear power, when Iran and North Korea have covered all the distance to a bomb. Therefore, they will claim, the Bush administration is confronted with not one but two disincentives to war.

The backroom changes on the geopolitical game board will be far more complex.

Russia is the key player. The significance of Russia rendering Iran nuclear assistance is pale compared with the effect of the Iranians going behind the Russians’ backs for North Korean help to test their bomb. The Russians are bound to feel threatened. Moscow and Tehran are still at odds over the division of the Caspian Sea and its oil resources. A nuclear-empowered Iran would tilt the regional balance of power away from Russia, Kazakhstan and Azerbaijan.

There are other complications. Moscow must shudder at the faintest prospect of Iran supplying the Chechen rebels with a bomb, particularly after their terrorist assault on a Moscow theatre on Wednesday, October 23, in which they held an audience of 700 hostage to a Russian troop evacuation from the breakaway province.

How would the Israelis regard the prospect of an Iranian bomb in the hands of the Iranian Revolutionary Guards parked on its northern frontier alongside the warlike Hizballah? The Iranian troops have already been issued with more advanced weaponry than the local Shiite terror group.

Putin, taken by surprise or feeling threatened – as he was twice this week, by the Iranian bomb and the Chechen theatre attack – may well reverse his former U-turn away from his former partnership with Bush and decide to support the US campaign to rid the world of terrorism.

Indeed, Russia's main objection to an American invasion of Iraq was less the prospect of Lukoil losing a lucrative contract, or Moscow forfeiting Iraq’s back debts of $8 billion, but rather that America’s defeat of Iraq and control of its oil flow would give Washington a hold over the Russian budget by manipulating oil prices.

News of a nuclear-empowered Iran may have the effect of chasing the Kremlin out of its current refuge with the status quo and force the Russians to face up to some hard options.

They could promote a nuclear-empowered Iraq as the best instrument for curbing Iran's ambitions in the region, or they could buy into the Bush-Cheney scheme for a partitioned federal republic of Iraq.

The second option would appear to be the lesser of the two evils. Quite simply, the Russians do not have the economic resources for imposing their military will on the Gulf-Middle East region for prolonged periods. An American partner would therefore be a safer prospect than a nuclear-armed Saddam.

French oil companies like Total Fina Elf, or marine construction companies like Technip Coflexip, will probably be the big losers from the new nuclear configuration. Iran's progress in opening up its upstream has been hampered by US embargoes. The disclosure of an unauthorized nuclear weapons program would surely roll back Iran’s progress in attracting foreign capital and technology to its oil sector. Indeed, with gargantuan natural gas reserves (nearly 15% of global total proved reserves), Iran's upstream would be out of reach once again for the hopeful western oil companies seeking to offset declining production growth after years of consolidation.