February 12, 2008

I am not taking my hand off of this hot stove until you say uncle!

Quico says: So, for the Nth time, Chávez has threatened to stop selling oil to the US. This was a non-story the last time it came around, and it's a non-story now. But since - like the magnicide canard - it seems sure to keep coming up, I thought I might explain precisely why it's a non-story.

At the moment, Venezuela's main trade relationship is with the US. We send them oil. They send us dollars. They really depend on our oil. But we depend on their dollars much more than they depend on our oil.

Chávez says he's ready to break this relationship. But if he does, what the heck is he gonna do with all that oil we're selling them now?

One thing's for sure, he can't get by without a replacement buyer: his government's stability depends on the revenue those sales generate.

Thankfully, in today's world there's never a shortage of oil buyers. So, lets say, he sells it to China.

There's just one problem: it's not like nobody sells oil to China now! These days China gets its oil, basically, from the Persian Gulf. That market is spoken for. To get into the Chinese market, Chávez would have to elbow the Arabs out of his way.

Lets say, hypothetically, he manages to do that. (And this's really hypothetical, because there aren't any refineries to process Venezuelan crude in China...but just for illustrative purposes.) Next thing you know...

The Gulf producers realize, "shit, we don't have a buyer for all that oil we used to ship to China!"

What to do? What to do?

Soon enough, the Gulf producers would go "Ah ha! Turns out that there's one big fat consumer out there that's suddenly facing a shortfall just as we're looking for a buyer for all our excess production!"

Lucky break, huh?

So they just move into the market that we've vacated!

And, in the end, all you've done is go from this:

To this:

When all is said and done, nothing's really changed. The US would be getting the exact same amount of oil as before, and Venezuela would be selling the exact same amount of oil as before. Same for China and the Gulf producers. Oil musical chairs.

Granted: in the short run, the adjustment would cause a great deal of disruption. That's why Chávez's threat still manages to spook the oil market to some extent. But everyone can see it's not a very credible threat because the disruption to the US would pale in comparison to the sheer chaos Venezuela would face during the adjustment period, when we wouldn't be able to sell our extra-heavy crude to anyone.

Very expensive new refineries would have to be built in China to process Venezuelan crude. What's more, PDVSA's refineries in the US would become practically worthless, because it would probably be cheaper to restart from scratch than to adapt them to process Gulf crudes.

Which, when you think about it, is deliciously ironic: Chávez is protesting the PDVSA asset freeze by threatening a policy that would make those assets worthless!

True, oil would have to be shipped longer distances to reach both the US and China, but all that means is that the real beneficiaries here would be, weirdly enough, South Korean companies like Hyundai that dominate the tanker shipbuilding business, alongside firms that operate tanker fleets. Consumers would pay a bit more for oil, producers would get a bit less for it, and the difference would go to the shippers. Oil socialism indeed.

The basic point here is that oil is a fungible commodity: its price is set in a global market, so it's sensitive to the total worldwide supply and demand levels, not to supply and demand in any particular bilateral relationship.

To grasp why, imagine what would happen if Venezuela switched its production from the US market to the Chinese market and the Gulf producers didn't respond by switching a corresponding amount of their output to the US. Suddenly, oil would be relatively more scarce in the US than in China. Oil prices would rise in the US at the same time they're falling in China.

But, at that point, any marginally awake oil trader (and oil traders, in general, are far more than marginally awake) would realize he faced a massive arbitrage opportunity. He could make a riskless profit by buying oil at the Chinese price and re-exporting it to the US for the higher price there. And traders would continue to do that until the prices equalize. Given today's electronic commodity marketplace, this process would run its course in a matter of seconds.

It's called the Law of One Price, y no perdona.

The only way Chávez can affect the global oil market in the long run is by reducing the overall supply level. He'd have to refuse to sell oil not just to the US but to anyone at all. But Chávez needs to sell his oil far more urgently than the US needs to buy it. So everyone can see it's an empty threat: like threatening to stain somebody's freshly whitewashed wall by shooting yourself in the head next to it.

Or, as Edo puts it: