$115/b Oil: The Edge Of Abyss

Oil prices hit a staggering $115/b yesterday, an amazing number given Chinese growth fears, abject German failures in the euro zone, and flat-lining growth in the US. The core reason prices hit a three month high, is not because of fundamentals, but because oil traders erroneously believe that Israel will go to war with Iran in October to choreograph its ‘nuclear putsch’ in time for US presidential elections. Nice try, but wrong call. The most geopolitically illiterate traders will lose their shirts when the sparks don’t fly come 1st October 2012.

To be fair, it clearly doesn’t help that Brent is losing its credibility as an international benchmark given localised supply outages in the North Sea, clipping production to a record low of 720,000b/d next month: Backwardation 101 time. It also doesn’t help that supply to the Mediterranean is down, with demand from refiners up (driven by higher margins). But when you take a look at broader fundamentals, it’s clear that $115/b is seriously overcooked given the amount of spare oil we have sloshing around. The IEA estimates that OPEC, (aka Saudi Arabia) has been pumping 2.1mb/d more than projected demand in April to June. Whatever Riyadh’s geopolitical reasons for doing so, that equates to 31.9mb/d in the second quarter compared to OPEC demand estimates weighing in at 29.8mb/d; marking the largest excess supply spread since 1998. The ironic twist with such a large cushion being built, is that’s it’s fed the rumour mill and expectation that the US (read Israel), is preparing for war with Iran in October 2012. Supplies are so plentiful that taking 3mb/d of Iranian production offline supposedly won’t matter. Storage facilities are already struggling to soak up any more supplies. Great economic theory on Iran; useless political practice.

If anything, excess supplies are being bulked up, precisely so the US can put more oil onto the market at times of its choosing via the IEA Strategic Reserve towards Presidential elections in November 2012. Washington wants to avoid any painful pricing pressures at US pumps to maintain the pretence of containing Iranian nuclear ambitions; it categorically doesn’t want to create ‘market space’ to bomb Iran for ‘electoral gain’. Taking on Iran now, would be akin to electoral suicide for the Obama administration. Tehran would undermine the bulk of Saudi, Iraqi and UAE production via slow burn rear-guard insurgency, not to mention explosively blocking the Strait of Hormuz. The tsunami of political ramifications that would bring to the Middle East would make the Iraq invasion look like a pleasant tea party (pardon the pun). Stockpiles are a short term political tonic to get Mr. Obama through presidential elections with the minimum of fuss, not a lethal injection to help wage a strategic attack on Iran. At $115/b traders beware, that’s perilously close for Washington to start drinking up some of the reserve as a short term fix – or at the very least – threaten to do so.

Indeed, it’s becoming increasingly clear that Iranian production has reached a ‘balancing’ point of 2.9mb/d to keep afloat. Unless the US goes for the jugular and stops Asian nations buying Persian crude, Iranian production will hold steady from hereon in – fresh supplies to South Korea, Iran, China and arguably even Japan, look increasingly likely thanks to sovereign balance sheets underwriting shipping liabilities in September. Then add Iranian off-take to incremental supply gains in Iraq, Libya, Sudan and Yemen, and it’s clear that $115/b oil is a one way bet on Israeli strikes on Iran. It plainly has nothing to do with US oil consumption down by 1.1%, unemployment rates above 8%, and more importantly, six consecutive quarters of dampened Chinese growth. The upshot; when the fuse doesn’t light in Iran, unless traders hold out for more explosive action into 2013 (a Romney win would clearly fuel that sentiment), it’s only going to be a matter of time before fundamentals kick back in and prices correct.

That raises the thorny question for producer states of how far prices could plummet. Even at $90/b virtually all producer states in the Gulf, Latin America and Eurasia would be remarkably nervous. This isn’t just a case of increasingly expensive social spending programmes that petro-states need to appease their restive populations, but paying off bureaucrats, oligarchs, security services, and most importantly, ongoing support of the military to politically shore things up. If prices significantly correct, most states won’t go for a ‘reform to perverse’ option, but fall back on what they know best, repressive measures to try and muddle through. Military hardware remains (in some cases) the first, but in all cases, the last line of political resort.

The snag is that such methods have no guarantee of success these days. It didn’t work for Gadaffi in Libya and it’s unlikely to work for Assad in Syria. Follow the argument through, and it’s clear that if the bulk of producers were struggling to hang on in a $115-120/b world, they stand little chance of pulling through in a $90/b (or less) environment. The lower prices go, the more likely political unrest creates serious supply disruptions affecting physical supplies as producers go offline. That would obviously put a radically new spin on what ‘cyclical’ means as far as price and political instability is concerned, but when we look across producer states, it’s hard to find any major players not sitting on a powder keg of political risk these days. That applies to some of the core producers in the Middle East, Eurasia and Latin America, as well as some of the smaller players that are likely to get caught in the cross-fire first.

That’s ‘good news’ for producer states lucky enough to remain intact and ride the price wave from smaller states imploding, but it’s a very dangerous game to play. Controlling market prices, let alone ‘gradations of instability’ in petro-states is a leap of faith even for the most oligopolistic of thinkers to make. And that’s the whole problem here – the gap between geological costs of production and the geopolitical cost of survival is simply too wide for producers to cover without falling back on draconian measures. If this ‘self-correcting’ mechanism between price and political unrest starts supporting an informal price floor then so be it, but we shouldn’t be fooled that this is serving anyone’s interests – on either side of the consumer-producer ledger. Yes, it will help firm prices when certain producers struggle to adapt to rapidly shifting economic conditions, but assuming that more and more producer states hit political problems as prices slip, we’re merely cementing the ‘too big to fail’ status of the very largest oil producers. It’s the antithesis of where consumers want to be in terms of fungible, diversified supplies.

So while traders willing to fly much above $115/b will get burnt at the top of the market right now, you’d only need to see a correction towards $90/b for political pandemonium to set in across producer states at the ‘bottom’. And guess what, the Iranian nuclear threat has been misread at both ends of the price spectrum. Until US elections are out of the way, it’s purely political pantomime, not a geopolitical fundamental (fundamental). For those, you need to keep looking elsewhere….

Forbes