Crude oil fell below $104/bbl today, despite continuing and worsening tensions between the US and Russia over Georgia.  Judged by the supply-scare hysteria which drove crude up from under $60 in early 2007, such worries should be sending crude soaring.  Instead, all told, NYMEX front-month crude futures have fallen almost 30% from their mid-July peak of more than $145/bbl, while fundamental considerations of physical supply and demand factors in that time have hardly budged.  What's going on?

My hunch is we are seeing at least a temporary sea change in US national security oil pricing strategy.  Instead of relentlessly driving up the price of crude to nose-bleed levels to crimp Chinese economic (and military) growth, the game plan has reverted, for now at least, to a downward pricing strategy aimed at reminding the Russians just how vulnerable they are to falling oil revenues.

Readers of “The Oil Card” will recognize that sharply lower oil pricing was the single most critical element in the Reagan Administration's successful effort in the 1980s to break the back of the Soviet Union.  It is a tried, tested and proven means to impact the oil-export-dependent Moscow regime, and it appears to be the weapon of choice again in responding to Russian uppityness in Georgia and elsewhere.

At a crude export rate of about 5 million barrels per day, a $50/bbl price drop equates to a daily revenue loss of some $250 million, or about $7.5 billion a month. With an accompanying drop in the price of Russian refined-product exports, the revenue decline could be well over $10 billion a month.   That has to have gotten the attention of Mr. Putin and his entourage.

It is interesting to note the precipitous turning point in oil pricing, in early July, actually presaged the movement of Russian troops into Georgia, as well as the provocative moves by US- and Israeli-trained Georgian troops to assault the breakaway province of Ossetia.  Satellite and other intelligence would have already been indicating the build-up of Russian forces across the border, however.  Who really started the Georgia conflict can be hotly debated.  Was Georgia the cause of current US-Russian tensions, or more the result of deeper animosities that have been building? What will it take to resolve US-Russian tensions?

Judging by news reports that Russia plans to garrison some 7,600 troops in Georgia, and  that the US plans a naval base in Georgia, it appears there is no resolution near at hand and the rift goes deep.  If so, be prepared for a much deeper dive in the price of crude oil,  and probably natural gas as well.  As the book notes, absent concerted efforts to prop up prices, global and fungible commodities like crude oil tend to sag to their marginal cost of production. That could be in the range of about $15/bbl for the international majors and under $10 for the Saudis.  If crude were to revert to its late-1990s level of about $10/bbl, adjusted for inflation, the price could fall back to around $20 or $25/bbl.

A more likely down-side price target, however, would be the price level at which Russian state finances, cash flows, credit ratings and stock market values come under severe pressure.  The DJ stock index of “Russian titans” is already off some 40% since  early June. Anything under $40/bbl now would probably give the Kremlin severe heartburn.  If Russian policies and rhetoric go uncorrected, you could see crude prices heading rapidly in that direction.

What does it take to quickly move prices down by such a large amount?  The same thing that drove them up: cash flows into and out of the commodity futures market.  Since mid-July, there has been a marked exit of cash from commodity index funds, which the book notes have been the main vehicle for channeling pension and other managed money into the relatively small oil futures market.  For a tally of those recent fund flows, check economic Phil Verleger's web site at http://www.pkverlegerllc.com/NAM-INDEX-TRADER-PAGE.PDF.


That shift to outflows comes after more than a year of huge inflows, which invariably went into the “long” (buy) side of crude futures contracts and overwhelmed the appetite of the “shorts.”   We now have seen the rapid deflation of that bubble, which had doubled the price of crude in less than a year.   Barring prompt and significant Russian actions to move back in line with US interests, look for the deflation to continue, perhaps in an incremental step-down manner with occasional pauses to the the Russians rethink their behavior.

Among the tell-tale signs that the US is managing crude prices lower:

1.)Release of SPR barrels after Hurricane Hanna to Citgo, despite minimal storm impacts to Gulf Coast refining or logistics.
2.)OPEC indications it will not cut output at its upcoming meeting, despite the price slide.
3.)Proposed US accounting changes that will let upstream companies report previously banned “probable and possible” reserves, thus inflating perceived oil resources.
4.)Likely resumption of drilling activity in restricted US coastal waters and Alaska.
         
Does this signal an end to the high-price oil strategy which I argue has been aimed at restraining Chinese economic growth since the later 1990s?   Probably not.  But some recent Chinese moves may have served to lessen the intensity of that effort.   Note that since last spring China has made nice with Japan in largely settling a long-vexing East China Sea boundary dispute which threatened to flare into military conflict.   It has also made nice with Taiwan.  And, perhaps most importantly, Beijing has apparently made good on assurances made to US Treasury Secretary Henry Paulson to speed up appreciation of the yuan.   There has also been some moderation in the outsized Chinese trade surplus with the US, and China has moved to pass through sizeable increases in its controlled fuel and power prices.  This could have bought China some easing in crude costs. 

Of course, lower crude and gasoline prices also benefit the US consumer and serve to damp Congressional outrage as we move into the fall election campaign.

Bottom line:  Lower crude prices, as with the severe run-up in recent years, are not an accident.   Nor are they simply the result of physical supply and demand fundamentals. They can and have been managed for geopolitical purposes.   That is really the only way to understand and anticipate these wild gyrations.