The Real Reason Energy Traders Are Losing Sleep

This time, it's Western politicians, not Arabian sheikhs, who are roiling the oil markets.

The oil crises of the 1970s taught Americans one of the iron laws of geoeconomics: that unrest in the Middle East can cause pain at the pump. But almost 40 years later, that law is blinding analysts to some of the most significant sources of market uncertainty -- which are right here at home. True, Iranian bellicosity and broader regional storm clouds are adding froth to oil prices. But even more striking is how much market-churning uncertainty is emanating from Washington and Brussels, rather than Caracas, Baghdad, or elsewhere in OPEC. The ambiguous economic trajectories and fluctuating policies of major energy-consumers like the United States, European Union, and China are proving at least as unsettling to oil prices as any decisions under the control of Middle Eastern officials.

Ask the leaders of OPEC what it's like to control the world oil market right now and they would probably laugh at your premise. Today's market jitters are largely beyond their control. The U.S. Federal Reserve's new open-ended commitment to expanding its balance sheet will likely push up the price of real assets like oil, even as White House chatter about dipping into the Strategic Petroleum Reserve (SPR) keeps the markets guessing about a sudden price collapse. At the same time, U.S. and European Union sanctions on Iran have crippled its oil exports, contributing to soaring oil prices and sparking demonstrations in downtown Tehran over the plunging value of the rial.

The potential for oil prices to shoot sharply higher or lower in the coming months due to events far outside OPEC's control is real, though still improbable. An Israeli military strike against Iran has the potential to drive oil prices skyward, just as the spread of Europe's debt crisis could cause oil markets to collapse. Add to this mix the threat of a so-called hard landing for China's economy or Washington falling over the fiscal cliff, either of which could send oil prices sharply lower. Yes, unrest in the Middle East is a continuous threat to stable oil prices, but political decision-making in the West and China is injecting more than its fair share of uncertainty into the market.

Part of this uncertainty is the result of policy incoherence in Washington. There is more than a little irony in the fact that the White House may decide to tap the SPR, the nation's 695 million barrel emergency fuel stockpile, to prevent a harmful rise in gas prices stemming in part from the decisions of the Fed. The mere announcement of the latest round of quantitative easing by Ben Bernanke, in addition to the already-loose monetary stance of other major central banks, was enough to send oil prices higher, only to crash shortly thereafter. The bounce would no doubt have been larger had many market participants not anticipated the Fed's decision. But the Fed's aggressive monetary easing is partly responsible for putting the Obama administration in the unenviable position of having to consider dipping into the SPR in order to keep a short-supplied market from pushing up prices too high.

And yet the policy dissonance in Washington has not been nearly so vexing to the oil market -- or to financial markets more broadly -- as the uncertainty surrounding the eurozone. Hardly a week passes without investors frantically buying or selling oil on the faintest whisper from the European Central Bank, Chancellor Angela Merkel, or the leaders of the most imperiled debtor nations. The unending lurch from Eden to Armageddon on trading floors around the world is typical of the so-called "risk on, risk off" capital-market mentality that has swept across every asset class -- and oil is no exception. Demand for oil correlates closely to global economic growth. When Europe's nagging ills appear on the mend, the outlook for growth appears brighter, causing oil prices to rise. Ditto on the flip side. But the sheer complexity of the problems facing European leaders, not to mention the uncertainty of domestic support for their policy prescriptions and the risk of cross-border contagion, mean oil prices have lurched to-and-fro with unusual velocity.

The prospect of a cataclysmic European tailspin is what economists call a left-side tail risk to prices: low in probability, but with the potential to topple the oil market should worldwide growth stall or even shrink. But right-side tail risk -- that oil markets might spike -- is also causing risk managers to lose sleep. The market's primary worry is an Israeli air strike on Iran, possibly with backing from or in coordination with the United States. If that happens, Tehran may well retaliate by disrupting tanker traffic in the Strait of Hormuz, the passage through which 35 percent of all traded seaborne oil flows. These are not idle fears. U.S.-led naval maneuvers in the Persian Gulf, which have included mine-sweeping drills, are already underway, and Iran has test fired missiles at ship-like targets near the Strait. Were Washington or its allies to launch a pre-emptive attack on Iran, oil prices would soar. Though Iran may be setting the stage for a confrontation, Western powers may end up being the ones to pull the trigger, setting off energy markets.

Even if such a conflict never materializes, efforts by the United States and the European Union to curb Iran's nuclear ambitions have already contributed to rising prices. Tightening U.S. sanctions and an EU ban on Iranian oil imports have caused the country's crude exports to fall to less than half of last year's average. This tightening of the screws has been disastrous for Iran, which depends on oil for 80 percent of its foreign revenue. By causing prices in the United States to rise, however, this strategy for bringing Tehran to the negotiating table has also been painful for American consumers. Whatever one thinks of the wisdom of sanctions in this or any other case, they have clearly caused global oil markets to labor under a strain that they would not have had to grapple with otherwise.

Still other wild cards remain far outside the control of OPEC. Market participants are already speculating about what measures Beijing will take to spur waning real economic growth. Oil has bounced along with other assets investors perceive as relatively risky, like emerging market equities, because of guessing about whether China might opt for more aggressive fiscal and monetary stimulus in the near future. Market fears persist about the possibility of a so-called Chinese "hard landing" and what it could mean for oil prices. Meanwhile, back in the United States, the much-discussed fiscal cliff looms. Its combination of tax hikes and spending sequestrations, due to drop in January if Congress fails to cut a deal, could weigh on domestic growth and hence oil demand. That loss could shave several percentage points off oil prices over the course of several years, according to a recent Citigroup analysis. Any mixed signals from Congress that cause Wall Street to question if or how it might tackle the approaching legislative deadline are sure to set off fireworks in the oil market in the meantime.

Make no mistake: Unrest in the Middle East has the potential to destabilize energy markets. With a civil war raging in Syria and North Africa in the midst of a trying transition period, it's not difficult to see how oil supplies could be interrupted. Trouble elsewhere in Africa, in places like the Sudan and Nigeria, is not helping matters. Given these realities, it's hard to imagine a scenario in which oil prices move significantly higher for an extended period absent something going wrong in that part of the world, which contains 70 percent of known oil reserves. Yet when it comes to sovereign decision-making, moves from Washington, Brussels, and Beijing may prove more unsettling to global energy markets in the months ahead than anything OPEC does.

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National Security

The Joint Chiefs of Lobbyists

Pentagon honchos loudly claim that national debt is the greatest security threat to America. They're dead wrong -- they just want more money for the military.

Bob Gates and Mike Mullen are not happy.

I don't mean they are unhappy on a deep, metaphysical, soul-crushing level, but rather on the more mundane level of "they think the country is going to hell" and they're not pleased about it. And why do they think this? It's the national debt.

Both Mullen (the former head of the Joint Chiefs of Staff) and Gates (the former defense secretary) have for several years now been publicly complaining about dysfunction in Washington, America's growing red ink, and the potential impact on their beloved military institutions. Most recently they have been on a tear about the prospect of sequestration cuts taking a meat ax to the Pentagon's budget. Two weeks ago at a Center for Strategic and International Studies (CSIS)-sponsored confab focused on the debt crisis in America, they made the argument again. Mullen repeated his now oft-repeated assertion that growing debt is the "most significant threat to our national security," and Gates renewed his claim that this will lead to cutbacks in military spending that will weaken the military at a time when America is facing myriad foreign threats.

Both men are wrong. The U.S. national debt isn't a security threat. Indeed, for all their high-minded rhetoric about the risks of growing indebtedness -- and their image as elder statesmen above the grubbiness of politics -- Mullen and Gates's goal is rather mundane and parochial: ensure that U.S. military budgets stay on their current inflated course.

At its core, the fundamental problem with the debt/national security argument is that, well frankly, it doesn't make much sense. National debt in and of itself isn't a threat. It's rather an issue of how that debt guides policy choices. So, for example, Mullen claims that "a nation with our current levels of unsustainable debt, being this far out of fiscal balance, cannot hope to sustain, for very long, its superiority from a military perspective or its influence in world affairs."

This is a highly dubious notion. There really is no reason a country even with unsustainable levels of debt (which isn't actually the case with the United States, which I'll get to later) can't maintain military superiority or influence in world affairs. Over the last three years -- as U.S. debt levels have risen dramatically -- the United States has intervened in a war in Libya, surged in Afghanistan, and, with the notable exception of drawing down in Iraq has done very little to pull back from a leading role in global affairs. Moreover, given how historically low interest rates are, there's reason to question the notion that America's deficit is "unsustainable" or that it couldn't be reversed by some good old economic growth and an expiration of George W. Bush's tax cuts. If anything, the problem in America today is that the country is disinclined to take on more debt in order to grow the economy.

Although it's certainly possible that more debt could mean a reduced U.S. role in the world, there's nothing about this scenario that's written in stone. Indeed, it should provide some comfort to Mullen that this year the House of Representatives took a sledgehammer to many social safety net programs like food stamps and Medicaid in order to spare the Pentagon the possibility of spending reductions. After all, if there is any lesson to take from how Congress handles military spending, it's that the country's elected representatives generally have the Pentagon's back.

In fact, at its core, Mullen's argument isn't really an argument against debt. He's not concerned about too much debt spending crowding out private-sector spending or about the long-term impact of debt on interest rates. He also seems largely unconcerned about the country's high unemployment rate or its underperforming economy, all of which, ironically, would be made worse by adopting Mullen's single-minded focus on debt, because spending cuts or broad-based tax cuts would almost certainly slow the economic recovery. Implicit in Mullen's argument is that to avoid cuts to the Pentagon budget, either other parts of government spending must be cut -- such as Social Security, Medicare, or other social safety net programs -- or taxes must be raised.

Of course, one might be inclined to argue that a reduction in military spending may not necessarily be a bad thing, especially when one considers that even the sequestration cuts that Mullen and others have described in apocalyptic terms would only return the United States to fiscal 2007 defense-spending levels.

For Mullen's argument to make any sense, he would actually need to identify why major reductions in military spending would put America at greater risk. For example, what emerging threat would the United States not be able to respond to because it suffered under the weight of around an 8 percent reduction from the current total Pentagon budget of $670 billion?

Mullen offers little clue, arguing instead, at the CSIS event, that America's "military missions and requirements abroad must and will continue" and that a budget decline "virtually guarantees that we would end up with a hollow force, a force unable to conduct its training, a force unable to maintain its equipment, and a force unable to fight."

Gates doesn't do much better asserting that "while there's no equivalent of the former Soviet Union looming on the horizon, I do believe the threats America faces today and down the road are, in many respects, more dangerous for their complexity, variety, unpredictability, and likelihood."

How these threats are more complex or dangerous to the United States than the possibility of planet-destroying thermonuclear war is left unstated -- along with any possible explication of what these threats Gates warns of might actually be. It's hard to take seriously an argument that argues debt is a serious national security threat because it will weaken the U.S. military when the proponents of this theory don't even identify an overseas danger worthy of having such a large military.

The closest Gates comes to putting some meat on the bones of his argument is this: "We need to be honest with the president, with the Congress, with the American people, and with ourselves … that a smaller, less ready, less modernized military will be able to go fewer places and be able to do fewer things.… If our elected officials and body politic conclude that they truly want a diminished role for the United States in the world, then we can start paring back missions and ratcheting back the corresponding military investments in force structure." 

The problem with this assertion should be obvious: Gates conflates a "diminished role for the United States in the world" with paring back military missions. But would that necessarily be the case? One might imagine that the United States can play an active global role in areas other than military adventurism. Indeed, Mullen takes a similar tack asserting that America's "tendency after war has always been to come home and isolate." (This sentence would make more sense if Mullen substituted the word always with never.)

With the possible exception of the post-World War I era, the United States has never truly "come home and isolated" itself; even in those years, the United States continued to play a role in global affairs, just not as a member of the League of Nations. After World War II, the Korean War, the Vietnam War, and the Cold War, the United States hardly isolated itself -- if anything, quite the opposite.

Even today, after two disastrous, debt-widening wars enthusiastically supported by both Mullen and Gates, one is hard-pressed to identify a single example of the United States pulling back from "global leadership" or engagement. No one is talking about getting out of NATO or ending support in the Far East for South Korea, Taiwan, or Japan. If anything, the U.S. support for allies in the region is on the upswing.

In reality, the only single example that one could possibly identify of U.S. "retreat" would be cuts to the defense budget -- and contrary to Gates and Mullen's protestations, that is hardly a symbol of isolationism.

And at a time when the United States has just finished one war and is winding down another, reducing the military budget is not so much "retreat" as it is a prudent response to larger changes in the global environment and America's overseas posture. It's not surprising that the former head of the Joint Chiefs of Staff and the former defense secretary would be opposed to such measures, but to argue that the debt is the root of the problem is to cloud the issue.

Indeed, this is what makes Gates and Mullen's rhetoric on the challenges of burgeoning so noxious. Gates, in particular, likes to argue that America's red ink represents a failure of political leadership in Washington, an adherence to parochial interests rather than doing what's best for the country. If only politicians could learn to compromise, says Gates, we could solve the country's problems.

But, of course, how one views the country's best interests differs from party to party and from congressman to congressman, from senator to senator. There are those who believe that raising taxes is the worst possible sin, others who feel the same about cutting social insurance programs, and finally those, like Gates and Mullen, who believe the defense budget must be protected at all costs. They are, quite simply, just one more interest group lobbying for their perceived national interests.

As they are decrying others' supposed parochialism, Gates and Mullen are engaging in the exact same activity by prizing national defense above other pressing issues of national concern.

Indeed, like so many politicians who criticize the country's red ink, it's hardly accidental that neither Mullen nor Gates describes how the country should get its fiscal house in order -- just that it should. Apparently, being an "adult" in Washington doesn't involve identifying who gets hurt by cutting the deficit, but, rather, criticizing those who don't share the same fiscal priorities.

Because of their positions of national prominence -- which are supposedly outside the realm of politics -- Gates and Mullen are accorded great respect and treated as serious voices whose opinions are selflessly intended to knock some sense into those in Washington who refuse to act like adults.

But though their verdict of parochialism being the disease that ails Washington might be correct, both men -- with their hoary defense of Pentagon budgets fueled by scaremongering claims about the result of reductions in military spending -- are really just part of the problem.

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