Japan, the Persian Gulf and Energy

Created ar 15 2011 - 14:05

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Over the past week, everything seemed to converge on energy. The unrest in the Persian Gulf raised the
specter of the disruption of oil supplies to the rest of the world, and an earthquake in Japan knocked out a string
of nuclear reactors with potentially devastating effect. Japan depends on nuclear energy and it depends on the
Persian Gulf, which is where it gets most of its oil. It was, therefore, a profoundly bad week for Japan, not only
because of the extensive damage and human suffering but also because Japan was being shown that it can’t
readily escape the realities of geography.
Japan is the world’s third-largest economy, a bit behind China now. It is also the third-largest industrial
economy, behind only the United States and China. Japan’s problem is that its enormous industrial plant is built
in a country almost totally devoid of mineral resources. It must import virtually all of the metals and energy that it
uses to manufacture industrial products. It maintains stockpiles, but should those stockpiles be depleted and no
new imports arrive, Japan stops being an industrial power.

The Geography of Oil

There are multiple sources for many of the metals Japan imports, so that if supplies stop flowing from one place
it can get them from other places. The geography of oil is more limited. In order to access the amount of oil
Japan needs, the only place to get it is the Persian Gulf. There are other places to get some of what Japan
needs, but it cannot do without the Persian Gulf for its oil.
This past week, we saw that this was a potentially vulnerable source. The unrest that swept the western littoral
of the Arabian Peninsula and the ongoing tension between the Saudis and Iranians, as well as the tension
between Iran and the United States, raised the possibility of disruptions. The geography of the Persian Gulf is
extraordinary. It is a narrow body of water opening into a narrow channel through the Strait of Hormuz. Any
diminution of the flow from any source in the region, let alone the complete closure of the Strait of Hormuz,
would have profound implications for the global economy.
For Japan it could mean more than higher prices. It could mean being unable to secure the amount of oil
needed at any price. The movement of tankers, the limits on port facilities and long-term contracts that commit
oil to other places could make it impossible for Japan to physically secure the oil it needs to run its industrial
plant. On an extended basis, this would draw down reserves and constrain Japan’s economy dramatically. And,
obviously, when the world’s third-largest industrial plant drastically slows, the impact on the global supply chain
is both dramatic and complex.
In 1973, the Arab countries imposed an oil embargo on the world. Japan, entirely dependent on imported oil,
was hit not only by high prices but also by the fact that it could not obtain enough fuel to keep going. While the
embargo lasted only five months, the oil shock, as the Japanese called it, threatened Japan’s industrial
capability and shocked it into remembering its vulnerability. Japan relied on the United States to guarantee its
oil supplies. The realization that the United States couldn’t guarantee those supplies created a political crisis
parallel to the economic one. It is one reason the Japanese are hypersensitive to events in the Persian Gulf and
to the security of the supply lines running out of the region.
Regardless of other supplies, Japan will always import nearly 100 percent of its oil from other countries. If it cuts
its consumption by 90 percent, it still imports nearly 100 percent of its oil. And to the extent that the Japanese
economy requires oil — which it does — it is highly vulnerable to events in the Persian Gulf.
It is to mitigate the risk of oil dependency — which cannot be eliminated altogether by any means — that Japan
employs two alternative fuels: It is the world’s largest importer of seaborne coal, and it has become the third-
largest producer of electricity from nuclear reactors, ranking after the United States and France in total amount
produced. One-third of its electricity production comes from nuclear power plants. Nuclear power was critical to
both Japan’s industrial and national security strategy. It did not make Japan self-sufficient, since it needed to
import coal and nuclear fuel, but access to these resources made it dependent on countries like Australia,
which does not have choke points like Hormuz.
It is in this context that we need to understand the Japanese prime minister’s statement that Japan was facing
its worst crisis since World War II. First, the earthquake and the resulting damage to several of Japan’s nuclear
reactors created a long-term regional energy shortage in Japan that, along with the other damage caused by
the earthquake, would certainly affect the economy. But the events in the Persian Gulf also raised the 1973
nightmare scenario for the Japanese. Depending how events evolved, the Japanese pipeline from the Persian
Gulf could be threatened in a way that it had not been since 1973. Combined with the failure of several nuclear
reactors, the Japanese economy is at risk.
The comparison with World War II was apt since it also began, in a way, with an energy crisis. The Japanese
had invaded China, and after the fall of the Netherlands (which controlled today’s Indonesia) and France (which
controlled Indochina), Japan was concerned about agreements with France and the Netherlands continuing to
be honored. Indochina supplied Japan with tin and rubber, among other raw materials. The Netherlands East
Indies supplied oil. When the Japanese invaded Indochina, the United States both cut off oil shipments from the
United States and started buying up oil from the Netherlands East Indies to keep Japan from getting it. The
Japanese were faced with the collapse of their economy or war with the United States. They chose Pearl
Harbor.
Today’s situation is in no way comparable to what happened in 1941 except for the core geopolitical reality.
Japan is dependent on imports of raw materials and particularly oil. Anything that interferes with the flow of oil
creates a crisis in Japan. Anything that risks a cutoff makes Japan uneasy. Add an earthquake destroying part
of its energy-producing plant and you force Japan into a profound internal crisis. However, it is essential to
understand what energy has meant to Japan historically — miscalculation about it led to national disaster and
access to it remains Japan’s psychological as well as physical pivot.

Japan’s Nuclear Safety Net

Japan is still struggling with the consequences of its economic meltdown in the early 1990s. Rapid growth with
low rates of return on capital created a massive financial crisis. Rather than allow a recession to force a wave of
bankruptcies and unemployment, the Japanese sought to maintain their tradition of lifetime employment. To do
that Japan had to keep interest rates extremely low and accept little or no economic growth. It achieved its goal,
relatively low unemployment, but at the cost of a large debt burden and a long-term sluggish economy.
The Japanese were beginning to struggle with the question of what would come after a generation of economic
stagnation and full employment. They had clearly not yet defined a path, although there was some recognition
that a generation’s economic reality could not sustain itself. The changes that Japan would face were going to
be wrenching, and even under the best of circumstances, they would be politically difficult to manage.
Suddenly, Japan is not facing the best of circumstances.
It is not yet clear how devastating the nuclear-reactor damage will prove to be, but the situation appears to be
worsening. What is clear is that the potential crisis in the Persian Gulf, the loss of nuclear reactors and the
rising radiation levels will undermine the confidence of the Japanese. Beyond the human toll, these reactors
were Japan’s hedge against an unpredictable world. They gave it control of a substantial amount of its energy
production. Even if the Japanese still had to import coal and oil, there at least a part of their energy structure
was largely under their own control and secure. Japan’s nuclear power sector seemed invulnerable, which no
other part of its energy infrastructure was. For Japan, a country that went to war with the United States over
energy in 1941 and was devastated as a result, this was no small thing. Japan had a safety net.
The safety net was psychological as much as anything. The destruction of a series of nuclear reactors not only
creates energy shortages and fear of radiation; it also drives home the profound and very real vulnerability
underlying all of Japan’s success. Japan does not control the source of its oil, it does not control the sea lanes
over which coal and other minerals travel, and it cannot be certain that its nuclear reactors will not suddenly be
destroyed. To the extent that economics and politics are psychological, this is a huge blow. Japan lives in
constant danger, both from nature and from geopolitics. What the earthquake drove home was just how
profound and how dangerous Japan’s world is. It is difficult to imagine another industrial economy as inherently
insecure as Japan’s. The earthquake will impose many economic constraints on Japan that will significantly
complicate its emergence from its post-boom economy, but one important question is the impact on the political
system. Since World War II, Japan has coped with its vulnerability by avoiding international entanglements an
relying on its relationship with the United States. It sometimes wondered whether the United States, with its
sometimes-unpredictable military operations, was more of a danger than a guarantor, but its policy remained
intact.
It is not the loss of the reactors that will shake Japan the most but the loss of the certainty that the reactors
were their path to some degree of safety, along with the added burden on the economy. The question is how
the political system will respond. In dealing with the Persian Gulf, will Japan continue to follow the American
lead or will it decide to take a greater degree of control and follow its own path? The likelihood is that a shaken
self-confidence will make Japan more cautious and even more vulnerable. But it is interesting to look at
Japanese history and realize that sometimes, and not always predictably, Japan takes insecurity as a goad to
self-assertion.
This was no ordinary earthquake in magnitude or in the potential impact on Japan’s view of the world. The
earthquake shook a lot of pieces loose, not the least of which were in the Japanese psyche. Japan has tried to
convince itself that it had provided a measure of security with nuclear plants and an alliance with the United
States. Given the earthquake and situation in the Persian Gulf, recalculation is in order. But Japan is a country
that has avoided recalculation for a long time. The question now is whether the extraordinary vulnerability
exposed by the quake will be powerful enough to shake Japan into recalculating its long-standing political
system.

John F. Mauldin
johnmauldin@investorsinsight.com