2006: The Year of the Balance Beam

As tempting as it may be to usher in the new year with a round of punditry and prophecy, I'll try to avoid speculating about what will happen in 2006, and instead just outline some possible events. There are a great deal of spectacular and monumental events that could happen in 2006, but in my opinion none of them are very probable. The thing is, dramatically improbable events happen all the time, simply because there are so many potential events that the occurrence of at least one is virtually assured, despite the improbability of each event individually. This is the troubling part about 2006: the sheer number of improbable but potentially catastrophic events that have raised their heads above water seems to me to suggest the great probability that at least one of them comes to pass. This situation is aggravated by the different gambits being put in play by many of the world powers, which with varying degrees of desperation and mutual incompatibility seem set to only exacerbate the situation. For that reason, I'm predicting that 2006 will be the year of the balance beam: imagine a few dozen bespectacled, middle-aged men sporting the full spectrum of gray attire trying to pass in opposite directions without pulling one another into the abyss. I forgot to mention that they're all connected with bungee cords. It could happen...

1. Bird Flu: Most likely won't happen this year, but it's certainly not impossible. But when it does come--and that seems almost certain at some point in the next 10-15 years--it will send shockwaves through every corner of the global system. A gradual onset over the course of several years would probably be best, but the sad reality of the current global health system is that we are most capable of preventing exactly the kind of gradual onset that could prevent an eventual, catastrophic outbreak.

2. Terrorism: Most likely there won't be an attack this year on the scale of 9/11, or even on the scale of Madrid or London. Most likely (notice the theme...). Al-Qa'ida, as a conceptual entity, is regrouping in Saudi Arabia, and will not likely crack that nut in the immediate future. The odds of a large-scale attack on the domestic United States are equally small--despite the evidence that several groups would like to proclaim their continued viability by such an attack, a smaller scale attack in Milan or Copenhagen is the most likely.

3. Iraq: Expect a settling period. The Iraqis have just concluded what was, by most measures, a "successful" election. But over the course of the new year the realization will gradually dawn that there is no correlation between a successful election and those elected politicians actually solving the country's problems. And they have many problems--most of which remain just as intractable as always. The insurgency has already shifted tactics following the elections to highlight just this problem--by shifting their focus back to the electrical system (and other infrastructure targets) they will undermine the ability of the democratic government to get anything done--aside from begin the creation of a de-facto system of channeling the majority of oil revenues to the Kurdish and Shi'a regions. Over the course of the year this will reverse the positive sentiment following the election and favor fragmentation. As this will likely proceed with few spectacular inflection points, however, it will be perceived as progress in the US--which will facilitate the decrease in US troop levels in Iraq. The "Iraqi-ization" of the counterinsurgency is a similar case of setting themselves up for failure--but it will be effective in furthering US policy interests. Talil Air Base will remain a safe point of departure for US planes, and the ability of the British to withdraw some troops from the South and the Norwegians to increase their oil partnerships in the North will prevent those countries from sliding ever closer to the Euro (which is an inevitable result of the peaking of North Sea oil production--the petrodollar standard only benefits oil producers that have significant US debt reserve holdings).

4. Iran: With the US military drawing down to perhaps less than 50,000 troops (more likely 80,000) by the end of 2006, along with the drawdown of some forces from Europe and South Korea, the US military will surprise many pundits with a reconstituted expeditionary capability. Equally important will be the forces that are not withdrawn from Iraq but are freed up for internal re-deployment (preventing the notification that is a de-facto result of re-deployment overseas from the US). All of which leads directly to a discussion of Iran and Syria. An almost unending stream of commentators have theorized that the US will attack Iran in March of 2006. Not at all likely--that's too early--but by the end of the year it will be certainly within the realm of possibility. Which demands a brief analysis of what kind of an attack that might be. A ground invasion is simply impractical--the terrain, size and population of Iran are vastly different from that of Iraq. Of course, the hubris of the current US administration is such that it can't entirely be ruled out--it just isn't very likely. More likely would be some kind of airstrikes aimed at Iran's nuclear facilities--by either the US or Israel. While there seems to be the kind of political will necessary to carry out such an attack in Israel, it isn't very likely to succeed. The Iranians just bought enough top-of-the-line Russian SA-15 surface-to-air missile systems to provide excellent point defense of their nuclear facilities--even some defense against cruise missiles and GPS-guided bombs. They'll take delivery beginning this Spring. Despite the rusty nature of Iran's Shah-era air force (Vietnam-era US fighters like the F-4 and older Soviet models), they also have been long rumored to have the Russian-built SA-10 system, which makes US Air Force planners wince. More significantly, however, is the political fall-out of a potential attack. It's my opinion that Israeli long-term interests would not be served by an airstrike, even if it successfully derailed the Iranian nuclear program for several years, as it would build resolve to finally get a bomb AND use it. US "interests" (by which I mean the current administration's), however, might be better served by such airstrikes, as it could create an environment of instability regarding Iran that would pressure early-adopters to shy away from Iran's euro-denominated oil bourse that opens this March. Which, of course, leads us to a discussion of oil...

5. Oil: What will oil do in 2006? It could hit $100/barrel, but that isn't very likely. More likely it will oscillate about $60/barrel, gradually working its way up to a stable $70 by year's end. It's necessary here to offer a disclaimer: an honest psychological self-evaluation suggests that I may be overly bullish on the price of oil as I have a substantial personal investment in (long-term) oil prices. That said, it will probably take more than one year before the reality of the depletion:discovery ratio really dawns on the broader financial powers, so prices will probably remain relatively flat this year. Unless, of course, Summer '06 exceeds Summer '05 in the Gulf-Coast hurricane category. How high a price can the current economy sustain before significant demand destruction kicks in? Well, prices in the late 70's and early 80's maintained a $70+/barrel level (in 2004 dollars) for quite a while without significantly decreasing demand (which eventually did happen, but more due to a recession that can't be solely linked to oil prices--it's a sticky point, I'll admit). In addition, by all measures we produce more GDP per barrel of oil burned today than we did back then (though not at double the level as some suggest--that is largely owing to the monetization of services in the modern economy). I think that prices of at least $100/barrel can be sustained with no appreciable impact on demand, but depletion rates over 5-6% could push prices far above that even with demand destruction. But there are really three factors that are pushing the price of oil upwards, only one of which is the "Peak Oil" phenomenon. The second is inflation. Oil prices will increase based on fundamentals, and they will also track inflation because it is not some fiat-commodity, but a commodity that has real value. So a 10% increase on fundamentals and 10% inflation will be additive. The third driver of oil price increase is the strength of the dollar. If the dollar drops 10% relative to the euro, then the price of dollar-denominated oil contracts will go up 10% because arbitrage between the US and Europe will keep the real price of oil roughly equal between the two. And if the Iranian oil bourse is a success, on thing that it will certainly do is depress the value of the dollar. It's also worth making a brief statement on oil exploration. Most commentators are suggesting that oil companies have increased the future price of oil assumption (the indicator that tells them which exploration ventures are acceptable from a financial risk perspective) from roughly $20/barrel to roughly $30/barrel. This is, conveniently, in line with the official line spouted by the oil majors and the Saudis. Privately, they mostly suggest that they aren't really convinced that oil will return to $30/barrel, but that it's a safe, low-risk assumption for their ventures. This price assumption is very important, because many market-economists who tout the salvation potential of oil-shale, tar-sands, gas-to-liquids and other higher costs oil options say that there is plenty of oil (hence no "peak oil"), but that we just need a slightly higher price assumption to see these supplies rapidly come on line--say $40 to $60/barrel. Well, these oil companies all employ numerous finance-MBAs, and any finance-geek worth their salt could tell you that with the December 2011 crude oil future currently trading at over $57/barrel, exploration ventures can utilize put-options to hedge against any price drop below current levels. Even with the cost of financing the options over time (which is significantly offset by inflations impact on oil prices), oil companies would have to be financially illiterate to not be using de-facto price assumptions in the $45 to $50/barrel range. My calculations suggest that the correct future price assumption from a financial risk standpoint is roughly $10/barrel below the price of the December futures contract 5 years out--in this case, CLZ11 (which closed today at $57.48, suggesting a price assumption of $45/barrel).

Well, I'll draw the line there on my 2006 overview. While I don't think that it will be a year that goes down in history any more than 2005, I certainly don't think that it will be boring.