Month: October 2014

DLF shares in debt spiral: Decoding why the stock fell 28% after Sebi ban

DLFVivek Kaul

The share price of DLF crashed today by 28.5% to close at Rs 104.95. In the process Rs 7439.5 crore of investor wealth was destroyed. Given that promoters own close to 75% of the company they had to bear a bulk of this fall.
In a landmark order, the Securities and Exchange Board of India(Sebi), barred DLF, KP Singh, the chairman and founder of the company, along with five other company executives from “buying, selling or otherwise dealing in securities, directly or indirectly, in any manner, whatsoever, for the period of three years.”
DLF failed to provide information on various subsidiaries as well as FIRs that were pending against it, when it re-listed in the stock market in 2007. (This blog explains the entire order in a very simple way).
Back then, the company had raised close to $2.3 billion through what was the biggest initial public offering until then. The Sebi order pointed out that “Noticees suppressed several material information in the RHP/Prospectus of DLF and actively concealed the fact about filing of FIR against Sudipti [a DLF subsidary] and others.”
The stock crashed today by 28.5% as investors sold out enmasse. The question is why did the investors abandon DLF today?
As on June 30, 2014, the company had a total debt of Rs 19,064 crore on its balance sheet. In the annual report for 2013-2014, the company points out that the “average cost of debt has continued to range between 12.5% and 13%.” This rate of interest couldn’t have changed much since then.
At 12.5%, the total amount of interest that the company needs to pay per year on an outstanding debt of more than Rs 19,000 crore, works close to Rs 2,400 crore per year or around Rs 600 crore per quarter. This is huge for a company which had sales of Rs 1,851 crore for the period between April and June 2014.
With the company paying huge interest on its outstanding debt, the finance charges stood at 30% of the total revenue during April to June 2014. This number has gone up over the years as the sales of the company have plummeted. For the period between April and June 2012, the finance charges were at 20% of the total revenue. The net sales for the period had stood at Rs 2,503 crore. The sales since then have fallen by around 26% to Rs 1,851 crore for the period between April to June 2014. The hope was that DLF would be able to bring down the value of its debts by listing a real estate investment trust (REIT), the rules for which were finalized last month. The company has close to 26 million square feet of leased assets. With the Sebi barring the company and its promoters from accessing capital markets, the company will now not be allowed to list a REIT in the next 36 months.
This means that the company will continue with a massive amount of debt on its balance sheet. This explains why the stock price fell by more than 28% today. It was simply adjusting to the new reality.
How did the company end up with so much debt on its balance sheet?
The company essentially borrowed a lot after it got relisted in the stock market in 2007. As on December 31, 2007, the total debt of the company had stood at Rs 3,702 crore. This jumped to Rs 7,066 crore by December 31, 2008, to Rs 12,830 crore by December 31, 2009 and Rs 22,758 crore by December 31, 2011. In a period of four years, the debt of the company jumped by more than six times.
The company borrowed a lot of money during this period to build a land bank and to diversify itself into other businesses which ranged from wind power to insurance and mutual fund to the luxury hospitality business. Since then, the company has been trying to come out of these businesses. During the last financial year, the company sold off its stake in the insurance business as well as DLF Global Hospitality Ltd.
This has helped the company to bring down its total debt marginally. The total debt of the company as on March 31, 2013, had stood at Rs 21,731 crore. This came down to Rs 18,526 crore by March 31, 2014. But has since then again shot up to Rs 19,064 crore.
The company will challenge the Sebi order. As it said in a release today “DLF will defend itself to the fullest extent against any adverse findings and measures contained in the order passed by SEBI. DLF has full faith in the judicial process and is confident of vindication of its stand in the near future.” Nonetheless, a close reading of the order suggests that the company is clearly on a weak wicket here. In fact, earlier this year, the Supreme Court had upheld a Rs 630 crore fine imposed on DLF by the Competition Commission of India. The Sebi order has made the situation worse for DLF.
To conclude, the mistakes made by DLF in the era of “easy money” seem to be catching up with it.

The article originally appeared on www.FirstBiz.com on Oct 14, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Money printing is ineffective: Why monetary policy, as we know it, is nearing its death

helicashVivek Kaul

Everything under the sun is in chaos. The situation is excellent.
– Mao Zedong

It has been a little over six years since the start of the current financial crisis in mid September 2008, when the investment bank Lehman Brothers went bankrupt. In the aftermath of the financial crisis the Western central banks went on a money printing binge.
Economist John Mauldin in a recent column titled The End of Monetary Policy estimates that central banks have printed $7-8 trillion since the start of the financial crisis. It is worth pointing out here that this money is not actually printed, but created digitally.
As John Lanchester writes in his wonderful new book How to Speak Money “It’s money that simply didn’t exist before. It’s like typing 100,000 at a keyboard and magically having £ 100,000 added to your bank account.”
Hence, this money is not actual printed money. As Tim Harford writes in The Undercover Economist Strikes Back: “A lot of it is money…not actual printed ‘paper money’ but ‘printing money’ is the simple way to talk about this.”
Once this new money has been created it is used to buy bonds, both private as well as government. This has been done to pump money into the financial system and ensure that there is enough money going around to keep interest rates low.
At low interest rates the hope was that people would borrow and spend more. This would create some demand and help economic growth. But has that really happened? The major creator of new money in the last six years has been the Federal Reserve of United States, the American central bank. It has printed (oops digitally created) around $3.6 trillion of new money since the financial crisis started. And it still continues to do so.
The hope as Henry Hazlitt put it in his book Economics in One Lesson is that “this increased money [will increase]…everyone’s “purchasing power,” in the sense of everybody to buy more goods than before.”
Nevertheless this hasn’t led to a jump in consumer expenditure. Household consumption forms nearly 70% of the American economy. As economist Stephen Roach wrote in a recent column “In fact, since early 2008, annualized growth in real consumer expenditure has averaged a mere 1.3% – the most anaemic period of consumption growth on record.”
This is reflected in the growth of the American GDP as well. As Roach points out “Though $3.6 trillion of incremental liquidity has been added to the Fed’s balance sheet since late 2008, nominal GDP was up by just $2.5 trillion from the third quarter of 2008 to the second quarter of this year.”
Hence, what economists call the “multiplier effect” hasn’t really worked.
The other hope was that all this new money would chase the same amount of goods and services, and this, in turn, would lead to some inflation. As prices would start to rise people would buy goods and services in the hope of getting a better deal.
But that hasn’t happened either. As John Mauldin writes “France has inflation of 0.5%; Italy’s is -0.2% (as in deflation); the euro area on the whole has 0.4% inflation; the United Kingdom (which still includes Scotland) is at an amazingly low 1.5% for the latest month, down from 4.5% in 2011; China with its huge debt bubble has 2.2% inflation.” The inflation in the United States is at 1.7%. This is below the Federal Reserve’s stated goal of 2%.
The only developed country which has managed to create some inflation is Japan. The inflation in Japan is at 3.4%. So has the money printing by Japan managed to create some inflation? Not really. As Mauldin explains “What you find is that inflation magically appeared in March of this year when a 3% hike in the consumption tax was introduced. When government decrees that prices will go up 3%, then voilà, like magic, you get 3% inflation. Take out the 3% tax, and inflation is running about 1%.”
Instead of reviving consumer expenditure and creating inflation, all the printed money has been borrowed by institutional investors at very low rates of interest and been invested in financial markets all over the world. Stock markets in various parts of the world have seen huge rallies despite economic growth stagnating. Central banks have hoped that these rallies might lead to a wealth effect. Wealth effect is a situation where the rising value of the financial assets makes people feel richer and hence, spend more money.
But that doesn’t seemed to have worked either. As Roach writes “The operative view in central-banking circles has been that the so-called “wealth effect” – when asset appreciation spurs real economic activity – would square the circle for a lagging post-crisis recovery. The persistently anaemic recovery…belie this assumption.”
This anaemic recovery is visible in the low economic growth rates prevalent through large parts of the developed world. As Mauldin writes “The European Union grew at 0.1% last year and is barely on target to beat that this year. The euro area is flat to down. The United Kingdom and the United States are at 1.7% and 2.2% respectively. Japan is in recession. France is literally at 0% for the year and is likely to enter recession by the end of the year. Italy remains mired in recession. Powerhouse Germany was in recession during the second quarter.”
What all this clearly tells us is that what central banks call “monetary policy” is not working as it is expected to. Investopedia defines monetary policy as “The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rate.”
The irony of course is that even though the monetary policy is not working the central banks around the world don’t seem to be in a hurry to get rid of it. The money printing programme in the United States has more or less come to an end. Nevertheless, the Federal Reserve has made it clear that it is no hurry to withdraw all the money that it has printed and pumped into the financial system. Hence, it hopes to keep long term interest rates low for sometime.
Other parts of the developed world though are still going strong on money printing. As Ben Hunt, Chief Risk Officer, Salient Partners, wrote in a recent newsletter titled Going Gray “The biggest thing happening in the world today is the growing divergence between US monetary policy and everyone else’s monetary policy. There is a schism in the High Church of Bernanke, with His US acolytes ending the quantitative easing [the technical term the economists have given to printing money] experiment in no uncertain terms, and His European and Japanese prelates looking to keep the faith by continued balance sheet expansion.”
Despite its non-effectiveness, central banks still have faith in monetary policy, as it has been practised over the years. And this might lead to monetary policy totally collapsing in the years to come.
To conclude, let me quote Mauldin: “Sometime this decade (which at my age seems to be passing mind-numbingly quickly) we are going to face a situation where monetary policy no longer works. Optimistically speaking, interest rates may be in the 2% range by the end of 2016, assuming the Fed starts to raise rates the middle of next year and raises by 25 basis points per meeting. If we were to enter a recession with rates already low, what would dropping rates to the zero bound again really do? What kind of confidence would that tactic actually inspire? And gods forbid we find ourselves in a recession or a period of slow growth prior to that time. Will the Fed under Janet Yellen raise interest rates if growth sputters at less than 2%?”
These are questions worth thinking about.

The article originally appeared on www.FirstBiz.com on Oct 13, 2014 

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

A bit rich: Why is discount king Kishore Biyani ranting against Flipkart sale?

Kishore_Biyani
Vivek Kaul

If you shout loud enough someone is bound to hear.
Over the last couple of days the offline retail players led by the likes of Kishore Biyani have been shouting from the rooftops about Flipkart and othe retail players indulging in predatory pricing and selling products below cost.
As a very patriotic sounding Biyani told The Economic Times “How can someone sell products below its manufacturing price? This is legally not allowed in the country. Someone can do such undercutting only to destroy competition. Just because they have foreign funding, they can’t kill local trade like that.”
He hasn’t been the only one whining against the discounts offered by the ecommerce companies like Flipkart. Praveen Khandelwal of Confederation of All India Traders (CAIT) said that the association has already approached the Ministry of Commerce. “We do not understand how online retailers gave 60-70% discounts. The prices at which they sold merchandise are lower than our purchase prices. This is a clear case of predatory pricing.”
These noises have reached the government. “We have received many inputs regarding Flipkart episode. Lot of concern have been expressed and we will look into it. Now there are many complaints. We will study the matter… Whether there is a need for a separate policy or some kind of clarification is needed, we will make it clear soon” Commerce and Industry Minister Nirmala Sitharaman said yesterday.
The first question is why should the government look into what is basically finally some healthy competition in the retail sector. Henry Hazlitt explains this beautifully in his book Economics in One Lesson. As he writes “The persistent tendency of men [is] to see only the immediate effects of a given policy, or its effects only on a special group, and to neglect to inquire what the long-run effects of that policy will be not only on that special group but on all groups.”
The offline retailers have managed to attract the attention of the government and now the government wants to look into the matter of discounts offered by ecommerce companies. Chances are that the government in the process of looking into the matter will fall victim to what Hazlitt calls the broken window fallacy.
So what exactly is the broken window fallacy? Hazlitt explains this through an example. A young hoodlum throws a stone and breaks a shop window. By the time the shopkeeper comes out, the boy has manage to disappear. A crowd starts to gather and a discussion starts. In sometime, the crowd decides rather philosophically that what happened was for the good.
As Hazlitt writes “After a while the crowd feels the need for philosophic reflection…It will make business for some glazier….After all, if windows were never broken, what would happen to the glass business?” The glazier will have more money to spend. And this will benefit other merchants. “The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be…that the little hoodlum who threw the stone, far from being a public menace, was a public benefactor,” writes Hazlitt.
On the face of it this sounds perfectly normal. But what it does not take into account is the fact that the shopkeeper will have to spend money in order to get the window repaired. And this money he could have spent on something else. In the example that Hazlitt has in his book the shopkeeper wanted to buy a suit. Now he can’t possibly buy the suit because the money has been spent on getting the window repaired.
As Hazlitt writes “The people in the crowd were thinking only of two parties to the transaction, [the shopkeeper] and the glazer. They had forgotten the potential third party involved, the tailor [who would have made the suit]. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye…It is the fallacy of overlooking secondary consequences.”
A similar thing seems to be playing out now in the battle between the ecommerce companies and the offline retailers. In the process the government, like the crowd in Hazlitt’s example, is likely to forget about the third party in the transaction i.e. the end consumer.
As I had explained in a piece yesterday, the end consumer has benefited from the discounts on offer by the ecommerce companies. While, there may have been problems with Flipkart’s recent Big Billion Day Sale, the discounts on offer on most days are genuine. And this benefits the consumers.
Ecommerce companies can offer these discounts because they do not require to maintain the massive physical infrastructure that offline retailers need to do. Over and above this, they do not need to maintain massive physical inventory and at the same time can cut through the distribution chain. These things help keep costs low, which in turn leads to discounts.
The end consumer benefits through discounts. He also now has more choice. Take the case of books. I am a big fan of crime fiction in general and Scandinavian crime fiction (translated into English) in particular. I can now buy almost all the Scandinavian crime fiction that has been translated into English from websites selling books. At the same time the choice of crime fiction available at a book store is fairly limited.
Let’s take another example shared by a friend who lives in a small town and has recently had a baby. The supply of quality diapers in his town is rather patchy. He now simply orders them online.
Further, the consumer also has more choice now when it comes to spending his money. If a consumer buys a product that costs Rs 1,000 offline at Rs 800 online, he is left with Rs 200. That money he can spend somewhere else. This will also benefit some business at the end of the day. The trouble of course is that no one knows where the consumer will end up spending the Rs 200 that he saves by buying online. Hence, a coherent argument in favour of the consumer cannot be made.
So, the likes of Biyani and his ilk may be complaining but the end consumer has benefited from the ecommerce revolution that is taking place. Another argument being offered is that ecommerce companies are taking over the business of offline retailers. As a retailer told The Hindu Business Line “The consuming class in India is in the age group of 18-30. Incidentally, they are also the ones who are driving up sales in the online space. This may erode our customer base.”
The next level of this argument will be that if this continues, then the offline retailers will have to start firing people. Hence, many people will end up losing jobs. The problem with this argument is that it again does not take the consumer into account.
Take the case of mobile phone retailers who are facing a tough time because of the discounts offered on mobile phones by ecommerce companies. The question is how many mobile phone consumers does this country have in comparison to mobile phone retailers. The number of mobile phone users is many many times the number of mobile phone retailers. So yes, mobile phone retailers are having a tough time, but the mobile phone users are benefiting (or have the potential to benefit) from the discounts being offered by the ecommerce companies and this cannot be ignored.
Further, the offline retailers have accused ecommerce companies of dumping their goods as well as predatory pricing. Sunil Jain demolishes these arguments in today’s edition of The Financial Express.
The question that Jain asks is that does Flipkart have the market power to dump goods? The entire e-retail sector in this country is selling goods worth around $4 billion, as per data from consulting firm Technopack. This is not even 1% of the $500 billion consumer market. And Flipkart is a fraction of that 1%. So, it doesn’t really have the market power to dump goods?
Further, Flipkart and other websites have been accused to selling things below cost. As Jain writes “Biyani and the others making this case will have to prove it. Just because a sale is taking place below the maximum retail price (MRP) doesn’t make it below-cost. Let’s say an article costs Rs 100 but has an MRP of Rs 200—that’s a pretty standard thing for most goods. The difference between the two is what comprises trade margins, shared between wholesalers and retailers. So as long as Flipkart is selling at over Rs 100, it is difficult to make a case for it selling below-cost—though…that is also permissible till such time that Flipkart is a dominant player.”
Also, if the selling below cost argument is taken to its logical conclusion then the “loss-leader” concept in retail chains will also have to come to an end. Investopedia defines this as a strategy “ in which a business offers a product or service at a price that is not profitable for the sake of offering another product/service at a greater profit or to attract new customers.” Airline seats being sold on a discount at the last minute will also have to stop.
It is worth remembering here that technical progress always throws people out of jobs and puts the incumbents in tough situations. Ecommerce is doing precisely that with offline retail. So does that mean there should be no ecommerce?
Hazlitt explains it best when he writes: “The technophobes, if they were logical and consistent, would have to dismiss all this progress and ingenuity as not only useless but vicious. Why should freight be carried from Chicago to New York by railroad when we could employ enormously more men, for example, to carry it all on their backs?”

PS: The irony is that Kishore Biyani who built a good part of his business by offering huge discounts over long weekends and thus created troubles for many a kirana shop, is now having problems with the same strategy.
The article originally appeared on www.FirstBiz.com on Oct 9,2014

 (Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Flipkart vs offline retailers: Kishore Biyani ko gussa kyon aata hai

Kishore_Biyani

Vivek Kaul 

Raghuram Rajan and Luigi Zingales in the introduction to their fantastic book Saving Capitalism from the Capitalists write “Those in power—the incumbents—prefer to stay in power. They feel threatened by the free markets.”
So who are these incumbents? “The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organised labour,” Rajan and Zingales write.
Something along these lines is currently playing out in the Indian retail sector. The incumbents (or what we can now call the offline players) are feeling threatened by the e-commerce companies, the new kids on the blocks. E-commerce companies like Flipkart, Snapdeal and Amazon have changed the rules of the game.
The e-commerce companies are gradually taking business away from incumbent offline players by offering huge discounts on products that they sell. One reason for the same is the fact that the ecommerce companies have managed to get around the inefficiencies built into the Indian retail system.
Professor Rajiv Lal of Harvard Business School explained this in an interview with Forbes India. As he put it “Basically the margins that are build up because some of our retail chain are inefficient. Think about the amount of inventory that is being held in the Indian apparel business. It is humongous. Stores are full of inventory and most of them don’t even know how much inventory they are holding. All that stuff is being reflected in the prices that we pay.”
The e-commerce companies don’t have to maintain huge inventories. If they manage to build up an efficient supply chain network, they can keep ordering goods as they go along. Hence, they do not to have maintain a large inventory like the offline players. This helps keeps costs down.
Also, like offline players they do not need to maintain a huge physical infrastructure like showrooms, godowns etc., to sell their goods. They can also buy goods directly from companies producing them and get a better deal in the process. These goods can be then directly sold to prospective consumers without having to go through an elaborate distribution channel.
Take the example of books being sold online. One reason why 30% discount on books being sold online is normal because the bookstore’s margin has been taken out of the equation totally.
Given these reasons, the costs of ecommerce companies are significantly lower than offline players, leading to them being able to offer products at a discount to the maximum retail price.
In fact, people have even started ordering goods like clothes and shoes, online. :Until a few years back nobody thought such products could be sold online. One reason for this is the attractive price. As Lal puts it “even situations that we think that it doesn’t make sense for people to buy things on the internet because of the inefficiencies in the Indian retail system, the price is so appealing that people are willing to compromise on other things.”
There are other reasons as well. Online companies allow buyers to return the product under a certain time period. This has given confidence to people to order products like clothes and shoes.
All this has pushed offline players into a corner. As a retailer told The Hindu Business Line “The consuming class in India is in the age group of 18-30. Incidentally, they are also the ones who are driving up sales in the online space. This may erode our customer base.” Given this, it is but logical that these retailers now questioning the basic business model of ecommerce companies.
As Kishore Biyani told Firstbiz yesterday “Laws in this country do not allow sales below cost price. This is anti-competitive. We (at Big Bazaar and other retail brands) never sell below cost price.” He did not clarify whether his company would be approaching the Competition Commission of India.
Praveen Khandelwal of Confederation of All India Traders (CAIT) said that the association has already approached the Ministry of Commerce. “We do not understand how online retailers gave 60-70% discounts. The prices at which they sold merchandise are lower than our purchase prices. This is a clear case of predatory pricing,” he went onto add.
It needs to be clarified here that not all products sold by online retailers are sold at 60-70% discount. This is the case only for special sales that they organise. Take the case of Flipkart’s recent The Big Billion Day sale. Products were given away at throw away prices when the sale opened at 8 am. But the website ran out of these products very soon. Amazon had also recently been selling books at a discount of 60%, though they did it in a very low profile way. But not all products are sold at such huge discounts all the time.
The offline retailers are reacting in a way that existing businesses react whenever their business model is threatened by a new business model or innovation. The first salvo has been fired and they have questioned the basic business model of the e-commerce companies.
I wouldn’t be surprised if this argument is repeated over and over again in the days to come. Henry Hazlitt explains this technique in Economics in One Lesson “The public hears the argument so often repeated…that it is soon taken in.”
In fact, the small and medium telecom retailers are trying to get telecom brands to stop supplying mobile phones to e-commerce companies. Aam Aadmi Party’s Adarsh Shastri is leading this effort.
As a recent news report in The Economic Times pointed out “It was at one such meeting mediated by Shastri last month that Samsung executives announced to the trade that it will go all out to limit or stop distribution to online sellers who are discounting products. More such meetings are lined up with other brands.”
The report quotes Shastri as saying “Nokia has been cooperating on this. Some brands are more disruptive than the others, like Samsung and even Apple, to an extent. But Nokia, Motorola and HTC have been reasonably open to the idea of price parity between online and retail channels.”
Shastri also said that “”wherever the common retailer is being bullied by a large brand or by the large muscle of online retail, we (AAP) will step in. If it is required tomorrow to take up issues of small retailers, the party will absolutely do it.”
The idea here is to ensure that small and medium telecom retailers continue to stay relevant and are not wiped out by e-commerce companies. While this sounds fair, the trouble with this idea is that it just takes into account one side i.e. the offline retailers. But what about the end consumer?
The question is why is nobody talking about the consumer? First and foremost the consumer is getting a better deal. Doesn’t that amount to something? Further, he has more choice now when it comes to spending his money. If a consumer buys a product that costs Rs 1000 offline at Rs 800 online, he is left with Rs 200. That money he can spend somewhere else. This will also benefit some business at the end of the day.
The trouble of course is that no one knows where the consumer will end up spending the Rs 200 that he saves by buying online. Hence, a coherent argument in favour of the consumer cannot be made. This explains why people like Shastri end up representing only one side of the argument.
Getting back to Biyani, he obviously understands the power of ecommerce and hence is hedging himself both ways. While in public he has been questioning the discounting practises of e-commerce companies, he may also be in the process of tying up with Amazon. As a recent report in the Business Standard points out “Biyani is in talks with Amazon to sell his private labels and sharing back-end facilities.”
To conclude, it is worth remembering that when an existing way of doing things is under threat, the incumbents are bound to react aggressively. This is what is happening right now with the retail sector in India. Nevertheless as Lal of Harvard put it “Why haven’t people asked the question, that should we have introduced auto-rickshaws and taxis because the rickshawallahs would have lost jobs?”
The article originally appeared on www.FirstBiz.com on Oct 8,2014 

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek) 

Death by oil: Why US and Saudi Arabia are colluding to drive down the price of oil

oil

Vivek Kaul

Oil prices have been coming down since the middle of this year. There are several reasons for the same, as I explained in a piece yesterday. One reason being suggested is that it is in the interest of both the United States as well as Saudi Arabia that oil prices go lower than they currently are. Further, these countries might even be colluding to ensure that oil prices are driven lower.
Before we get into the details, it is important to discuss some history here. At the end of the Second World War, the American President Franklin Roosevelt realised that a regular supply of oil was very important for the well being of America and the evolving American way of life. He travelled quietly to USS Quincy, a ship anchored in the Red Sea. Here he was met by King Ibn Sa’ud of Saudi Arabia, which was by then home to the biggest oil reserves in the world.
The United States’ obsession with the automobile had led to a swift decline in domestic reserves, even though America was the biggest producer of oil in the world at that point of time. The country needed to secure another source of assured supply of oil. Hence, in return for access to oil reserves of Saudi Arabia, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud.
Over the years, Saudi Arabia has also ensured that Organization of Petroleum Exporting (OPEC) continues to price oil in US dollars. This has been a major reason behind the American dollar continuing to be the international reserve currency. Given this, the United States and Saudi Arabia have always had a close relationship which has proven beneficial to both the countries.
The recent past has seen the rise of the Islamic State of Iraq and Syria (ISIS) which is trying to redraw political boundaries in the Middle East. As analysts of Bank of America-Merrill Lynch points out in a report titled Does Saudi want $85 oil? “Recent advances by the Islamic State in Syria and Iraq have disrupted Middle East politics. The Islamic State aspires to bring any areas where Muslims live under its control…[It] rejects political divisions established by Western powers at the end of World War I.”
This scenario has led to a situation where Saudi Arabia is cooperating with the United States to keep oil prices down. Typically, oil prices start to rise at the sign of the slightest trouble in the Middle East. Nevertheless, that hasn’t happened this time around. The major reason for the same is that the ruling clan of the Sa’uds wants the United States to keep the security guarantee that Roosevelt gave them, going. In fact, in September before addressing the United States on the threat of ISIS, President Barack Obama is supposed to have called up Saudi Arabia’s King Abdullah Bin Abdulaziz Al Saud.
The ISIS has captured oilfields in Syria and Iraq. This oil is sold at a discount to the world price of oil, to Turkey, which in turn, resells it in Europe. It is estimated that ISIS earns around $3 million from oil sales. By driving down price this earning can be driven down as well. Hence, United States and Saudi Arabia can ensure that they are able to cut down the funding of ISIS.
And how is this being done? Typically, whenever oil prices start to fall, Saudi Arabia starts to cut down on production, so that oil supply comes down, and this immediately slows down the fall in price. But that doesn’t seem to have happened this time around. As the Bank of America-Merrill Lynch analysts point out “We have yet to see a Saudi output cut in response the lower prices. Oil has fallen $15/bbl[barrel] from a peak of $115/bbl in mid-June, but Saudi production has not bulged.”
This has helped keep oil prices down. The threat is that ISIS might want to go beyond Syria and Iraq in the days to come. “It should perhaps not come as a surprise that the threat of a stateless group that challenges the status quo by attempting to redraw national borders is shifting incentives for key regional and global players…The Islamic State could present a direct threat to the Arab monarchies at a time of growing social discontent…In our view, Saudi and other regional rulers may prefer to reengage the US to help protect established borders from the expanding caliphate. What could Arab countries offer the West to help contain this threat? Lower oil prices,” the Bank of America-Merrill Lynch analysts point out.
An interesting comparison to this situation is the time when Iraq attacked Kuwait more than twenty years back. As Thomas Piketty writes in Capital in the Twenty-First Century: “If the United States, backed by other Western powers had not driven the Iraqi Army out of Kuwait in 1991, Iraq would probably have threatened Saudi Arabia’s oil fields next, and it is possible that other countries in the region, such as Iran, would have joined the fray to redistribute the region’s petroleum rents.”
This explains very well, why Saudi Arabia needs the security guarantee from the United States, and in return it is offering a lower price of oil. A lower oil price also helps the United States and other western powers neutralize Russia, which in 2013 was the biggest producer of oil in the world, having produced 13.28% of the oil being produced globally.
There are other political factors at work as well. The Kurds have been demanding autonomy from Iraq and are being allowed to sell oil at a lower price. As Vijay Bhambwani, CEO of BSPLIndia.com explains “The Kurds have started selling high quality arab light grade sweet crude at US$ 55 / barrel. Initial despatches were to Israel. Since the Kurds have a militia of 55,000 strong fighters (Peshmerga) which is funded by oil sales, the western countries are allowing the Kurds to sell their oil below market prices in return for fighting the ISIS forces.”
Over and above this, there is the case of Iraqi cleric Muqtada Al-Sadr, son of the slain chief cleric of Iraq under Saddam Hussein’s rule. As Bhambwani explains “Al-Sadr is the founder / commander of the Mehdi army which is dominated by Shias and is pro Iran. If he seizes power, he is likely to re-negotiate oil contracts with the west, keeping the Saudis on tenterhooks. Saudis are therefore open to hiking output and cutting prices.”
In fact, by cutting the price of oil, the Saudis also hope to neutralize the shale oil boom in the United States and Canada. This boom has led to the United States and Canada producing much more oil than they were a few years back. Data from the U.S. Energy Information Administration shows that United States in 2013 produced 12.35 million barrels per day. This is a massive increase of 35% since 2009. In case of Canada the production has gone up by 22.8% to 4.07 million barrels per day between 2009 to 2013.
But shale oil is expensive to produce and it is financially viable only if oil price remain at a certain level. As Bank of America-Merrill Lynch analysts point out “With production costs ranging from $50 to $75/bbl at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment.”
In the end, there is enough evidence to conclude that Saudi Arabia has been working towards pushing down the price of oil, in order to ensure that the United States security guarantee continues.
The article originally appeared on www.FirstBiz.com on Oct 8, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)