It's easy to call an opponent's bluff in a game of high stakes poker, when you hold four Aces, and your only worry is being trumped by a straight flush. By camouflaging its refusal to cease uranium enrichment with a detailed offer for "dialogue," Tehran scoffed at UN Security Council Resolution 1696, which called for Iran to suspend its uranium enrichment by August 31st, or face economic and diplomatic sanctions.

Iran started enriching uranium on January 10th, and with the exception of Security Council Resolution 1696, which took six months to craft, has paid no price for it. Iran's Islamic rulers rely on the staunch support of their Russian and Chinese aces to counter any punitive measures devised by Washington. Holding out the glimmer of negotiations also drives a wedge between the US and the Europeans, who love the idea of dialogue and engagement.

France began to fold its cards at the table on Sept 8th, when French Foreign Minister Philippe Douste-Blazy indicated that Paris might be flexible over its previous demand that Iran must suspend its uranium enrichment work before resuming even more negotiations. He also added that, "Iran should be considered as a great civilization, we need to engage in a dialogue that shows respect for this country," he said.

Tehran has maneuvered skillfully, exploiting divisions, playing for time, coaxing better offers, while moving closer to completing the research, development and experimentation stages needed to operate its nuclear facilities at full capacity, the so-called point of no return towards building the Jihad bomb. Still, the neo-cons in Washington don't believe a word from the mullahs, and the hardliners in Iran are convinced the US wants regime change.

Since hitting an all time high of $80.37 per barrel on July 14th, the US light crude oil contract for October delivery has tumbled by $12.60 /bl to as low as $67.77 /bl on Sept 7th. Crude oil traders are exasperated with the diplomatic wrangling at the United Nations, and are downplaying the imposition of any type of sanctions against Iran, or the long rumored US military attack on its nuclear installations this year.

Traders are busy unwinding a big chunk of the $10 to $15 per barrel Iranian "war premium" that was built into prices earlier this year. But beyond the game of Russian roulette over Iran's drive to join the nuclear club, there's always the possibility that the most recent slide in crude oil prices heralds the onset of a significant global economic downturn. And the fall-out from the volatile shifts in world oil prices will also determining the next winners and losers in the global marketplace.

Defying the Laws of Supply and demand

For the past two years, crude oil prices have doubled, while US crude oil inventories increased by roughly 22% during the same time period. Spot oil prices climbed the slippery slope to as high as $78.40 /barrel, supported by fears of supply disruption due to Iran's nuclear program, attacks on Nigeria and Iraq's oil pipelines, and political mischief by Venezuela's Hugo Chavez. On the demand side, a robust world economy, growing at a 5% annualized clip, led by China and India has underpinned oil demand, enabling prices to defy the laws of gravity.

"While markets have traditionally relied on available spare production capacity to respond to any unexpected supply problems, under current tight capacity conditions, market participants instead are apparently opting for a large inventory cushion as protection," the US Energy Information Agency said in February. "Thus, until either spare capacity increases significantly across the entire supply chain, or many of the perceived uncertainties in the market are removed, oil markets could see high inventories coexist with high prices for the foreseeable future."

Fueling the Chinese Dragon

With 1.3 billion people, the People's Republic of China is the world's most populous country, its second largest oil consumer of 7 million barrels per barrel, yet only a third of daily US oil consumption. China's economy expanded at an 11.3% annualized rate in the second quarter, its fastest in a decade. As such, China's demand for energy is projected to increase by 150% by 2020, and its oil consumption is expected to grow by 7.5% per year, seven times faster than the US.

Though during the 1970's and 1980's China was a net oil exporter, but it became a net oil importer in 1993 and is growingly dependent on foreign oil. China currently imports 43% of its oil consumption and is expected to increase its need for imported oil by 75% between now and 2010. The International Energy Agency predicted that by 2030, Chinese oil imports will equal imports by the US.

"If the Chinese economy were to continue to grow in real terms at a rate 7% greater than that of the United States economy at a constant exchange rate, as it has for over 20 years, its GDP would indeed overtake that of the US in about another quarter century," Bank of Israel chief Stanley Fischer told central bankers from around the globe at Jackson Hole, Wyoming. "Furthermore, the yuan is likely to appreciate over that period relative to the dollar, reducing the length of the catch-up period," he added. A stronger yuan, coupled with rising Chinese demand is still a potent formula to keep oil prices historically high.

In the first seven months of 2006, China's crude oil imports grew to 84 million tons, a 12.9% rise over the same time last year. China's foreign exchange reserves hit a record $954.5 billion in July, and Beijing is always on the prowl for new oil deals in far-away places like Kazakhstan, Russia, Venezuela, Sudan, West Africa, Iran, Saudi Arabia and Canada, to meet the needs of its rapidly expanding industrial base. China's emergence in recent years as the world's second largest consumer of oil puts it in direct competition with the US for global energy resources.

China is planning to acquire a stake in Argentina's oil and gas firm Pluspetrol, has signed energy and transport agreements worth $10 billion with Brazil, covering projects that include a gas pipeline, power plants and a trans-Amazon road linking Sao Paulo to Lima. In Bolivia, Beijing plans to invest $1.5 billion in the state-run oil and gas company YPF Boliviano. In Ecuador, China has purchased $1.4 billion in assets from a Canadian oil company operating two major oil pipelines.

Venezuela becomes an Emerging Tiger on Global Scene

Venezuela currently has around 80 billion barrels of proven oil reserves, and its existing oil output of 3.3 million barrels per day is the fifth largest in the world. It is the fourth largest oil supplier to the US, after Canada, Mexico and Saudi Arabia. But Caracas says it also controls around 235 billion barrels of crude oil reserves in the vast Orinoco Belt, which if correct, would give it the world's largest oil supply.

In 2005, the oil sector accounted for roughly 16% of Venezuela's economic output, 87% of export earnings, and about half of the central government's ordinary revenues. Tapping into a surge in crude oil exports and a near tripling of the country's foreign reserves over the past three years, Caracas aims to prepay some of its most expensive foreign debt and reduce its debt service by $600 million per year.

The central bank transferred $6 billion of FX reserves to the National Development Fund in 2005, to prepay $4.7 billion of foreign bonds and bank loans this year. The Venezuelan payoff would see its total national debt fall by 15.2% to $26.3 billion, and Finance chief Nelson Merentes says the government aims for Venezuela's debt to be lower than 25% of gross domestic product by the end of 2008.

Venezuela's current account surplus jumped 33.5% in the second quarter of 2006 from a year earlier to reach $8.27 billion, even after paying off $4.7 billion of foreign debt. The surge in Venezuela's foreign currency reserves to $9 billion surplus above its foreign debt, has nearly halved its 10-year borrowing costs from two years ago. As long as oil prices remain high, chances are good that Latin America's fifth largest economy can continue to build-up its FX reserves and keep its bond yields low.

Venezuela's Chavez Cements an Alliance with China, Iran, and Russia

Venezuela's strongman Hugo Chavez has been a key player, sewing up a de-facto alliance between three major energy superpowers, Iran, Russia, and Venezuela, and the world's second largest oil consumer, China. All four countries view the US invasions of Iraq and Afghanistan, and threats against Iran, as a strategy to control the huge strategic oil and natural gas reserves in the Middle East and Central Asia. Closer ties between Beijing, Caracas, Moscow and Tehran therefore, are seen as a counterweight to US interests in the Middle East and Latin America.

In his visit to Beijing last month, Chavez agreed to expand oil exports to supply China's rapidly growing energy needs, in return for political backing and economic aid. "China is one of the world's largest consumers of oil and Venezuela is one of the biggest oil producers, so we complement each other completely," Chavez declared. He called for a "strategic alliance" with China to foster a "multi-polar" world and to challenge the "hegemony" of the United States.

In Beijing's Great Hall of the People, Chavez promised to increase oil exports to China from the current level of 155,000 barrels per day to 500,000 by 2009 and one million by 2012. Chinese state oil companies are also working on a project in the Orinoco River basin and offshore exploration. On August 28th, Venezuelan Energy Minister Rafael Ramirez said Chinese state-owned oil companies would invest $5 billion in energy projects in Venezuela by 2012, lessening the country's dependence on oil exports to the US, and help increase production to 5.8 million bpd by 2012.

Following Chavez's visit to Tehran on July 29th, Iran's Oil Minister Kazem Vaziri-Hamaneh said Iranian firm Petropars would invest $4 billion in the Orinoco Belt to develop reserves there, and supply services to the Norte de Paria offshore gas field. Iranian investors have already poured $1 billion of investment into Venezuela, primarily in sectors such as energy, construction and tractor-building. Venezuela's Ramirez mentioned the possibility of exporting petrol to gas-guzzling Iran.

President Chavez hugged his Iranian counterpart Mahmoud Ahmadinejad in Tehran on July 30th, and blasted their common enemy, the Bush administration. "If the US Empire succeeds in establishing its dominance, there will be no future for humanity. Therefore, we should save humanity and end the American empire," Chavez told a crowd at the University of Tehran.

A smiling Ahmadinejad presented Chavez with the golden "High Medallion of the Islamic Republic of Iran" and slipped a blue sash around his chest. "Mr Chavez is my brother, the brother of the whole Iranian nation and of all freedom-seeking people in the world. He is a perpetual warrior against the dominant system, a worshipper of God and a servant of the people," he added. Chavez also threatened to cut off oil exports to the US, if either Caracas or Tehran are threatened in the future.

In an earlier meeting with Vladimir Putin on July 27th, Moscow said it had sold 24 fighter aircraft and 53 attack helicopters to Venezuela, defying the United States which has urged Moscow to halt arms sales to Venezuela's Hugo Chavez.

The Beijing - Tehran Connection

China and Iran are bound by energy deals reaching a total value of $120 billion and growing. China's oil giant Sinopec Group signed a $70 billion oil and natural gas agreement with Iran, which is China's biggest energy deal with the #2 OPEC producer. Sinopec will buy 250 million tons of liquefied natural gas over 30 years from Iran and develop the giant Yadavaran field. Iran is also committed to export 150,000 barrels per day of crude oil to China for 25 years at market prices after commissioning of the field.

On Sept 5th, Chinese Premier Wen Jiabao promised to veto economic sanctions against Iran. "Imposing sanctions on Iran may even prove counter-productive. The parties involved should be cautious about moving towards sanctions," Jiaboa said. This may indicate not only that China is interested in a militarily strong, even nuclear Iran that dominates the Gulf but also that for China, energy security considerations trump international cooperation on critical global security issues.

Beijing has also provided to Iran, shipments of anti-ship cruise missiles, which pose a threat to oil tanker traffic in the Strait of Hormuz, and American naval vessels operating there. In the recent skirmish between Israel and Hizbollah, Iran's proxy army in Lebanon fired a Chinese silkworm missile nearly destroyed an Israeli naval boat off the coast of Beirut.

Beijing's High Wire Act with US and Europe

Still, Jiaboa must do a high wire balancing act, to maintain good relations with Tehran and Washington at the same time. China's trade surplus widened to a record $14.5 billion in June, as exports jumped 23% from a year earlier, taking the 12-month rolling trade surplus to $126.8 billion. China's good fortune came largely at the expense of the US, which ran a trade deficit with China of $17.7 billion. In May, US exports to China increased 4.6% to $4.5 billion, while imports rose 4.1% to $22.3 billion. The shortfall showed signs of more deterioration in June.

In its crusade against Iran's nuclear weapons program, Washington has tried to draw the European Union to its side. The EU is China's biggest single trade partner, and trade reached $143.5 billion in the first seven months of 2006, a 21.1% increase over the same period last year. The EU said its trade deficit with China reached 106 billion Euros ($135.9 billion) in 2005. Thus, when push comes to shove, Beijing might find it difficult to cast a veto against its biggest trading partners in the UN, if a tough sanctions resolution actually comes to a vote.

But while the diplomatic wrangling at the United Nations drags on for a few more months, Chinese customs agents reported a sharp decline in crude oil imports to 10.5 million tons in July and August, or 16% lower than in April-May. The sharp decline in Chinese oil imports, caught crude oil traders off guard, and might have spooked speculators into dumping over-extended long positions. Still, it's difficult to know whether the sharp decline in Chinese oil demand is just an aberration, which could be followed by a big rebound in September.

Will Japan Split from US in row with Iran?

Japan buys nearly 15% of its crude oil imports from Iran, and imports virtually all its oil. Nippon Oil Chairman Fumiaki Watari declared on Sept 6th, that if the United Nations imposes sanctions on Iran over its nuclear programs his company likely will turn to Russia, and other countries in the Middle East and elsewhere to make up the shortfall. Tehran is exerting heavy pressure on Nippon Oil, Japan's biggest refiner, to break its alliance with the US at the United Nations.

Tehran has warned that it could seek another country to lead development of its Azadegan oil fields if Japan does not begin construction on the project soon. But Tokyo is under pressure from the United States not to proceed with the deal. Still, Japanese Finance Minister Sadakazu Tanigaki said on August 23rd, "Given Japan's high reliance on Iran for oil, it won't be so easy for Japan's economy to stop importing it. While the issue of nuclear non-proliferation is very important for Japan, securing sufficient oil supplies is in the national interest," he declared.

Time is running out for Nippon Oil, because Iran has set a September 15th deadline for its Japanese partner to finalize their 2004 agreement. Watari says not only is China eyeing the undeveloped Iranian fields but France's Total oil company also has expressed interest in developing the Islamic Republic's largest onshore oil reserve. Also, Watari said his company has begun tapping Russia's rich energy resources. For the first time, Nippon Oil has purchased crude oil from Russia's Sakhalin region. The 700,000 barrels of oil are to arrive in Japan next month.

Russia Profits from Tension and Terror in the Middle East

Which ever way the UN sanctions debate blows, the Kremlin expects to be a big winner from balance of tension and terror in the Middle East. Russian crude oil production hit a new all-time high of 9.8 million barrels per day in August, largely a result of the Exxon-led Sakhalin-1 field coming on stream. Russian oil and gas sector accounts for 31% of its gross domestic product, and provides for 50% of the Kremlin's tax revenue.

The recent ramp-up in production has made Russia the world's biggest oil producer, surpassing Saudi Arabia. Still, it should be noted that Russia has taken the top spot only by pumping at full tilt while Saudi Arabia has several million barrels of production capacity in reserve. With the recent slide in crude oil prices however, the Russian oil exports have tapered off by 7% to 4.45 bpd in September.

Russia's foreign trade surplus rose to $86.2 billion in the first half of the year from $66.3 billion in the same period a year ago. Exports surged to $143 billion, up 31.3% from a year ago. Crude oil exports totaled 126.7 million metric tons in the same period, and accounted for 34.6% of Russian exports last year, and 32.1% in 2004. Russian exports of natural gas, armaments, defense technology, ferrous and non-ferrous metals, metal products, fertilizers, petrochemicals, grain, timber, and coal, provided other reliable sources of foreign exchange earnings.

Standard & Poor's upgraded Russia's foreign currency debt rating by one notch to BBB+ on Sept 4th, as the Kremlin reaps a huge bonanza from high oil prices. Russia paid back its $22.5 billion debt to the Paris Club of sovereign creditors ahead of schedule last month. Russia's gold and forex reserves, the world's third largest, have reached $258.5 billion, a fourfold increase since 2003, and its general government debt should fall below 10% of gross domestic product next year.

OPEC Monitors the Crude oil market

According to the Institute of International Finance, an umbrella group for 340 of the world's private-sector banks, the export earnings for the six of the Gulf Co-operation Council (Saudi Arabia, United Arab Emirates, Kuwait, Oman, Qatar and Bahrain) will top $500 billion this year. About 80% of that will come from oil and gas, a threefold increase in four years. For the GCC as a whole, gross domestic product per capita over the past three years rose from $11,000 to $17,000.

OPEC is due to meet on Sept. 11th, with the ability to influence oil prices, at least in the short run. The 11-member cartel has been producing at close to full capacity since the beginning of the year, apart from Saudi Arabia, which still holds spare volumes. However, Riyadh has been discreetly cutting back on oil production to 9 million bpd this week, amid the recent tumble in prices. While OPEC wants to maximize its oil income, it does not want to push the global economy into recession.

Saudi Aramco ramped up production to around 9.5 million bpd during the first quarter of last year before cutting back to 9.0 million bpd in August '06. Saudi Arabia is the swing producer within OPEC, with an estimated 2.2 million bpd of spare capacity, mostly of the sour blend, that is costly to refine. Riyadh was unable to halt the surge in crude oil prices over the past two years, but could be more successful in placing a floor under the market, when it decides to significantly cut oil production.

But the in the case of Saudi Arabia, about 60% of its oil exports go through the Persian Gulf, through terminals located at Ras Tanura (6 million bpd capacity), and Ras al-Ju'aymah (3 million bpd). Saudi Arabia a lso operates two major pipelines, the East-West Crude Oil Pipeline (Petroline) to Red Sea terminals for export to European markets, and the Abqaiq-Yanbu gas liquids pipeline which serves Yanbu's petrochemical plants. Saudi Arabia, the world's largest exporter of crude oil, would be significantly affected if Iran tried to close the Strait of Hormuz.

Slide in Crude Oil Takes pressure off Federal Reserve

The sharp slide in crude oil prices since the Federal Reserve's last meeting on August 8th, vindicates the central bank's decision to hold rate steady at 5.25%, ending a string of 17 consecutive rate hikes over the past 26 months. Fed chief Ben Bernanke views the fed funds rate of 5.25% as "consistent with satisfactory economic performance," minutes of the Fed's August 8th policy meeting showed.

If crude oil stays below $70 per barrel for a sustained period of time, the Fed could maintain a steady rate of 5.25% at the upcoming September 20th and October 25th meetings. "Members generally saw limited risk in deferring further policy tightening that might prove necessary. The housing downturn, higher energy prices and past interest-rate increases were expected to hold economic growth below potential over the next six quarters,'" the Fed said on August 30th.

The US economy slowed to an annual rate of 2.9% in the second quarter, down from 5.6% in the prior three months, igniting worries about weaker US demand for crude oil. Japan's economy was worse off in Q'2, slowing to a 0.8% annual growth rate from +2.7% in the previous quarter. However, the slowdown in the world's two largest economies was offset by explosive 11.3% annualized growth in China, and a 2.4% growth rate in the Euro zone in Q'2, its best performance in four years.

For most of 2006, the US Treasury bond vigilantes have tracked the general direction of oil prices, the key variable behind headline inflation in the US and global economies. The Bank of Japan has also drained 26.5 trillion yen ($228 billion) out of the Tokyo money markets since March 9th, while the Fed has hiked rate three times this year, sapping some of the speculative excess out of the crude oil market this summer. While the Fed and BoJ are expected to remain sidelined through November, the European Central Bank still has two more rate hikes on tap.

A Showdown with Iran in 2007?

The war of words is still running hot. On Sept 6th, Richard Lugar, chairman of the US Senate's Committee for International Affairs, labeled Russia, Iranian and Venezuela as "hostile countries." "Energy has now become the preferred weapon for all who possess it. Countries that are faced with the suspension of energy supplies or even with the threat of such a suspension could fall into despair, leading to the increased likelihood of an armed conflict, terrorism and even economic collapse."

In Moscow, Vladimir Trofimov, deputy head of the foreign ministry's Middle East department, told the Interfax news agency on Sept 7th, "If we look at Israeli and US plans, they aimed at removing the Hizbollah factor ahead of the forthcoming US settling of accounts with Iran. This was a US-Israeli conflict with the Islamic world, in which Iran has become a de-facto leader," he observed.

In a September 5th speech in Washington, US President George W. Bush took the threats of Iranian president Mahmoud Ahmadinejad very seriously. "History teaches that underestimating the words of evil and ambitious men is a terrible mistake. In the early 1900's, the world did not heed Lenin's words, and paid a terrible price. In the 1920's, the world ignored Hitler's words, and his Nazi regime killed millions in the gas chambers, and set the world aflame in war, at a terrible cost in lives," Bush said.

"The Shia and Sunni extremists seek to impose a dark vision of violent Islamic radicalism across the Middle East. Imagine a world in which they were able to control governments, a world awash with oil, and they would use oil resources to punish industrialized nations. And they would use those resources to fuel their radical agenda, and pursue and purchase weapons of mass murder. And armed with nuclear weapons, they would blackmail the free world, and spread their ideologies of hate, and raise a mortal threat to the American people."

"America will not bow down to tyrants. I'm not going to allow this to happen, and no future American President can allow it either," Bush declared.

Would Iran Shut-down the Strait of Hormuz, if attacked?

Iranian leaders have frequently threatened to shut down the flow of oil through the Strait of Hormuz, roughly 16 million barrels per day, if the United States pursues sanctions against Iran or strikes its nuclear development program. On August 3rd, Iran's Foreign Minister Manuchehr Mohammadi said "the first consequence of these sanctions would be an increase in the price of oil to around $200 per barrel."

"If the country's interests are attacked, we will use all our capabilities, and oil is one of them," Iranian Oil Minister Kazem Vaziri-Hamaneh was quoted on June 25th. "The world needs energy and understands the effect on the market of oil sanctions against Iran, and no-one will make such an unreasonable decision," predicting sanctions against Iran could push crude up to $100 a barrel.

On June 4th, Iran's supreme leader Ayatollah Ali Khamenei also gave the United States a staunch warning. "We should not sell out this precious resource because of the enemies' threats and we should not be fooled by enemy bribes. You threaten Iran. You say you want to direct energy in the region. If you make a single mistake about Iran, the supply of energy will definitely be put in serious risk," he said.

But would Iran actually carry out its threat to shut down the Strait of Hormuz, an act that could also lead the implosion of its economy and the likely downfall of the Ayatollah's regime? Iran's economy relies on oil exports for 85% of its foreign exchange earnings and 55% of the government's budget. Iran's revenues from oil export in 2005 were $46.6 billion, and projected to increase to $60 billion in 2006.

Also in 2006, Iran will consume 462,000 bpd of refined gasoline and will import 188,000 bpd, or roughly 41% of its total consumption. Iran buys its gasoline through a European oil trader, Vitol, with another 15% coming from an Indian refinery. But Iran also subsidizes gasoline prices from the government's coffers, which sell for less than 40 US-cents per gallon to the public.

If the US knocked out Iran's oil refineries and interrupted both its exports of crude oil in the Gulf region and the import of gasoline to Iran, with unemployment rates as high as 20%, any disruption in both food and gasoline subsidies, as a result of the drying up of oil revenues, could trigger violent Iranian street uprisings and lead to the downfall of the Ayatollah's regime within a few months.

For this reason, Iran might respond to US military strike against its nuclear facilities by targeting Israel with Shahab-3 missiles or sabatoging Iraq's 2 million bpd of oil exports, instead of provoking US wrath by shutting down the Strait of Hormuz. That might be a risk worth taking by both Israel the Bush administration in 2007, to disrupt the existential threat of a nuclear armed Iran.

Does the Bush administration hold a straight flush, capable of beating Iran's four aces? The governments of the 26 IEA member countries own about 1.5 billion barrels of oil in strategic reserves. That would be enough to compensate for a loss of all of Iran's oil exports for at least a year and a half. Furthermore, the IEA members also have access to another 2.5 billion barrels that could be used if necessary, said IEA agency's director general Claude Mandil on August 23rd.

For now, sentiment in the crude oil market is ruling out these dire scenarios, after placing great faith in them for the past 12-months. But with a schizophrenic market, where sentiments can turn on a dime, it's best to keep to short-term predictions.

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