Prussian military theorist Carl von Clausewitz one famously stated that " war is a mere continuation of policy by other means".
By this he meant that war is not merely a political act but a real political instrument and a continuation of political commerce that seeks to achieve political goals. Clauswitz's ideas regarding war were epitomized by the Franco-Prussian War from 1870 to 1871.
Throughout the ages, war has been used as a tool of policy by a range of governments, however with the end of World War Two its use increasingly became unacceptable in the global community and fell into disrepute. Not that this stopped conflicts but rather saw many re-characterized as sectarian conflicts, political actions or police actions.
Such a move is not surprising with the increasingly interconnected and interdependent nature of the global community making medium to high intensity conflict almost impossible to prosecute as a means of achieving political aims. It as however brought to the fore a range of other tools for continuing policy without engaging in open warfare.
These are becoming increasingly important policy tools in a multi-lateral world dominated by a single superpower, where open conflict is frowned upon and invites severe political and economic consequences. And it is this coupled with the nuances of Middle-Eastern politics that is driving the sustained slump in oil (NYSEARCA:USO) and the global supply glut.
The seeds of war
The crude oil war is not a tale of open conflict, mass casualties and governments on the verge of collapse but rather a covert economic war declared by OPEC or more specifically Saudi Arabia as a means of ensuring its preeminence in global oil markets.
The first perceived threat was the rise of the U.S. to eventually become the world's largest oil producer by 2014 on the back of the shale oil boom.
There were signs early on that the Saudi's feared the shale oil boom with multi-billionaire investor Prince Alwaleed bin Talal in 2013 calling American shale oil production an inevitable threat. He went on to state that rising U.S. oil production because of the shale oil boom was a direct threat to the Kingdom's oil dependent economy because it would reduce demand for crude from OPEC.
In fact, by mid-2013 OPEC customers were limiting their oil imports and displacing considerable export volumes to the U.S. a key OPEC customer and added to the growing global surplus. This caused Saudi crude output to fall and it was creating ever larger ripples of concern in a country where oil plays a pivotal economic role.
It accounts for roughly 75% of budget revenues, 45% of GDP, and 90% of export earnings, highlighting just how dependent the kingdom has become on crude. Not only was the petroleum industry essentially funding their domestic economy and financing important internal programs aimed at reducing internal dissent in a political fractured country, it was also funding Saudi ambitions of remaining relevant as key regional power.
In an increasingly volatile Middle-East, where the Saudi's were determined to remain a credible regional force economically and militarily, any threat to funding their regional ambitions was viewed with considerable alarm. The end result was that the Saudi's concluded they couldn't bolster prices by cutting production because U.S. shale output would grow and thereby fill the gap.
Meanwhile, other non-OPEC members were also ready to swoop in and fill the void created by Saudi production cuts, with high oil prices providing an ever greater incentive to oil producing nations to boost output. This included an international rogue's gallery with Russia, Mexico, Colombia, Argentina and Kazakhstan all hungrily eyeing the vast profits that could be made from boosting their output of crude, especially with pries hovering around the $100 mark.
This left the Saudi's with one option; let prices fall to test how long and at what levels U.S. shale oil producers could keep pumping.
The next driver was the ever growing rift between Iran and Saudi Arabia, which is driven primarily by religious ideology and regional power politics with both countries jockeying to be the dominant regional power. This has triggered a regional proxy war between the Saudi's and Iran as they jockey to determine who will become the preeminent regional power and influencer.
This is yet another reason for the Saudi's reluctance to reduce production.
You see, Iran had made it extremely clear that it was seeking to boost its own revenues from crude and reinvigorate its waning oil industry as a means of dragging the country out of the economic morass it had found itself in since the early 90s. A key goal of Teheran was to have the sanctions imposed for refusing to suspend its uranium enrichment program lifted by agreeing to limit its nuclear program.
Not only does Teheran need the revenues that additional oil exports would generate for its domestic economy, it is also caught in protracted and costly conflicts across the Arab world that require funding. These merely represents the hotspots of the ongoing proxy war between Iran and Saudi Arabia.
The escalating conflict for religious and political control
Now that the sanctions have been lifted Iran has made it clear that it refuses to even contemplate agreeing to production caps or freezes, with it determined to lift its oil output by 1.5 million barrels daily to a total of 4.5 million barrels.
Nonetheless, as the graphic shows there is some doubt as to whether Iran can lift production that high without a longer lead in time to develop its oil fields as well as much needed foreign expertise and capital.
Source: U.S. EIA.
As a result, many analysts expect output from Iran to only rise to around 3.5 million barrels daily but this is still enough to asset alarm bells ringing and keep pressure on prices.
In reality, for Riyadh it is particularly alarming because it will allow Iran to further finance its escalating involvement in the proxy war the two states are now fighting in Syria and Yemen.
It will also allow Iran to strengthen its military, boost aid to various countries and organizations across the Middle-East and nurse its ailing economy back to health. Iran along with Russia is supporting Assad in Syria and this is costing Teheran billions of dollars annually with it providing financing, military advises, subsidized weapons, lines of credit and oil.
Meanwhile, the Saudi's are supporting various anti-government rebel groups and participating in the airstrikes against Islamic State.
Then there is Riyadh's costly intervention in Yemen where it intervened militarily to support the government of President Abd Rabbuh Mansur Hadia against the Shiite Houthi revolutionaries.
All of these are applying pressures to the kingdom's finances and could be a very real reason for the failure of the Doha conference earlier this month.
Yet another flash-point
One of the biggest flash-points for the war by crude was the conference in Doha where the world's largest oil producers met in an attempt to set production freezes and bolster the price of crude. The conference was an abject failure and may have been scuttled from the start with the Saudi's making it clear they wouldn't agree to production freezes unless other major oil producers including Iran and Russia also agreed.
Iran which desperately needs to reinvigorate its economy and boost government revenues has made it clear it will never agree to a production freeze after being released from the yoke of Western sanctions.
As a result, Teheran is determined to boost its oil production as quickly as it can in order to rapidly bolster its revenues. The graphic from Bloomberg illustrates that Iran could be generating up to five times its sanctions revenue from crude by the end of 2016.
That is just bigger chunk of change to throw away especially when you're looking for every penny you can get.
There is also the escalating enmity between Saudi Arabia and Russia which manifested itself at the Doha conference.
After the talks collapse the Saudi's threatened to flood the market with crude by boosting its production to 12 million barrels per day or 21% higher than it is currently. In response, Russia said it was prepared to push oil production to historic highs and this has been an item on Putin's agenda since the price collapsed as Moscow has battled to fund the shortfall created by sharply weaker crude.
According to Moscow this would see it raise output to as high as 13 million barrels daily or 18% above current levels.
It could be postulated that the Saudi's saw sharply weaker crude prices as a political weapon that could be used to pressure Moscow into ceasing or at least winding back its support for Assad's Syrian government.
And there is certainly some veracity to be lent to this theory.
Russia is engaged in direct intervention, funding and support for a range of low intensity conflicts across Eastern Europe and Central Asia, including the military intervention in the Ukraine, supporting Assad in Syria and the ongoing insurgency in the Caucasus. Then there is the need for Moscow to fund its various aid programs to regional allies and suppress various minorities who continue to seek political independence.
In a world awash with crude along with Saudi Arabia threatening further increases in output and Iran hell-bent on boosting output the factors do not bode well for any sustained recovery in oil any time soon.
The costly impact of Riyadh's policy
The biggest question for many is how can the Saudi's continue to pursue this policy?
Not only are the losing considerable amounts of revenue but other OPEC members are experiencing tremendous pain with some approaching the verge of economic collapse. Fiscal breakeven prices for the majority of OPEC members are well above $70 per barrel as the graphic illustrates.
While the data in the next chart sourced from the IMF is slightly different it illustrates the point that crude is well below the fiscal breakeven price for all OPEC members at this time.
Source data: IMF.
This is creating considerable financial pressure and even distress for a number of OPEC members with Venezuela and Nigeria among the most vulnerable, because of their economic dependence on crude and the weakness of their economies.
Already, Venezuela is mired in a deep economic crisis that is seeing shortages of basic everyday items, while its government as burnt through over $7 billion in currency reserves and inflation has spiraled to over 60%. Nigeria is also feeling the pinch and any marked shortage in government revenue has the potential of creating a coup as well as fomenting further unrest among Islamic militants with less resources being available for suppression programs and military funding.
Both countries along with other cartel members have protested to OPEC but to no avail with Saudi Arabia effectively locked into its strategy, despite the economic cost to itself.
The shift to a wartime economy
Even more startling is the idea that Saudi Arabia may in fact be shifting to a wartime economy so that it can continue the supply war that it has launched.
You see, it too is suffering considerable financial pressure with it needing between $103 and $106 per barrel to breakeven. For 2015 the Saudi's posted a record budget deficit of $98 million which represents about 16% of Saudi Arabia's GDP.
Now with prices still not recovering because of the ongoing supply glut Riyadh has had to cut spending for its 2016 budget and consider ways of generating additional income. For the 2016 budget, government spending is down by 14% and the budget is expected to run a deficit of $87 billion, with it predicated on $45 per barrel crude.
The Kingdom has also had to drain its foreign currency reserves in order to sustain the pursuit of keeping oil prices low in order to regain market share.
Between February 2015 and February 2016 its foreign currency reserves have fallen precipitously, plunging by 17% as the graphic shows, as it has battled to finance it's the revenue shortfall its pursuit of the policy has created
Source data: Saudi Arabian Monetary Agency & US EIA.
This trend will continue until the kingdom can balance its budget either through higher oil prices, a significant reduction in spending or boosting other forms of non-oil revenue.
An important consideration here is that while Riyadh's foreign currency reserves can't last forever, they are very deep and will help to support the ongoing implementation of this policy if he Saudi's can effectively cut other forms of expenditure and raise revenues from other means.
One of which is the Kingdom's decision to make a partial public offering of the state owned oil company Aramco by listing up to 5% of the company. This will create one of the biggest IPOs ever with it worth around $100 billion to $150 billion and help to defray the impact of sharply weaker oil prices. Deputy Crown Prince Mohammed bin Salman outlined the plan this month and stressed that it formed part of a move to make the Kingdom less reliant upon oil revenues and expand private enterprise.
Regardless of these claims, it smacks of the Saudi's moving to shore up their financial position so they can continue using the war on crude as a key means of achieving their political aims. It also demonstrates the lengths that they will go to in order to maintain its policy on crude until it has obtained its objective, which it claims is to boost its market share, but increasingly appears to be subsumed by irrational logic.
Saudi Arabia's determination to ruthlessly pursue its strategy of keeping the spigots open and pumping crude besides the damage it is doing to its economy and that of other OPEC members shows no signs of stopping any time soon. In reality, the war over crude supply has become an integral part of its policy package as it seeks to head off a range of external threats and once again become the world's dominant oil producer.
It appears that the kingdom sees the economic conflict that it is waging as a continuation of policy by other means, but it should really be seen as an economic war with the ability to cause more damage to the kingdom's opponents than a hot war. There are no signs of the kingdom changing its policy and moving to cease pumping crude at record levels anytime soon, which certainly doesn't bode well for the outlook for oil prices despite the recent rally.
In that respect, there are even signs that the kingdom may have lost sight of its original goal with the U.S. shale oil industry proving to be far more resilient to weaker oil prices and Iran and Russia determined to boost output regardless of the price. This sees it trapped in a classic case of cognitive dissonance, pursuing the current policy for the sake of policy and not having to admit they were wrong, regardless of the damage it is inflicting on the Kingdom and other cartel members.
If this is the case it is unlikely that there will be any revision in the policy with it appearing that the Saudi's regard this as a key means of achieving their policy goals across a range of economic and geopolitical theatres. For these reasons, I would not be surprised to see crude remain at current levels for the remainder of 2016 or even fall below $40 per barrel because of supply and demand fundamentals remaining out of balance.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.