The G-factor is back

February 3, 2011 | 00:00

The G-factor is back

Energy analyst Matthew Hulbert wonders, if markets are already jittery about unrest affecting small players such as Egypt and Tunisia, what will happen if major oil producers are affected? One thing is certain: after two years of “fundamentals” dictating oil prices, the “geopolitical factor” has returned to the oil market. And it is sending a strong message to OPEC: better quell the market now, or it might crush you later.

If any further evidence was required that we are back in a bull oil market, then Egypt has done the trick. Benchmark prices have breached $100 per barrel directly on the back of the political turmoil in Cairo. This is not because Egypt sits on much oil, but because it’s an important transit route for Middle Eastern oil to global markets via the Suez Canal, and home to the Sumed pipeline linking the Red Sea to the Mediterranean. In conjunction these two routes carried over 2.5 barrels per day (mbpd) into Europe, about 15% of European imports. If either of these routes were to be closed, oil tankers would have to be diverted 6,000 miles around the southern tip of Africa.

A classic case of price movements linked to fundamentals then? Well perhaps, but when we consider that excess supplies still top 5 mbpd from OPEC ranks alone, the record becomes a little more suspect. We all know that speculation plays a hand in oil, and commodities have undoubtedly been driven up by rabid asset rotation of late, but the critical point to note is that geopolitics is ‘back’ for the market – and it will be back with a vengeance in a $100/b world. Buckle up: the ride is about to get bumpy.

Nightmare on Wall Street

We have of course been here before. In the run up to the $147/b July 2008 peak every scrap of geopolitical friction was used to push up prices. This ranged from the death of Benazir Bhutto in Pakistan late 2007 to failed Presidential candidate Hilary Clinton firing a ‘virtual warning shot’ across Iranian bows. A supposed ‘Andean cataclysm’ in Latin America between Venezuela and Colombia was the icing on the geopolitical cake for investors building up net long positions in crude oil futures. Taking note of falls in US employment figures or weakened growth in Asia wasn’t part of the narrative; talking the market up towards $200/b was however, at least if you worked for Goldman Sachs.

That was until the financial crisis hit. Post-Lehman nobody wanted to be the next nightmare on Wall Street. Positions were rapidly unwound to realise capital gains and release liquidity. And although

Markets are fickle when it comes to pricing geopolitical risk in or out the market; the key question is, just how fickle?
genuine demand destruction was firmly setting in as prices slumped to as low as $33/b (early 2009), the market still had more than enough geopolitical ammunition to firm prices should it have wished. But no: the Russo-Georgian war, Evo Morales fighting for his political life in Bolivia, fresh Iranian threats to block the Strait of Hormuz – all was brushed aside. All that mattered was how credibly OPEC, and more specifically Saudi Arabia, was willing to set a price floor via massive production cuts.

Barricades

The fact that we are getting back towards a pre-July 2008 ‘geopolitical’ market, despite conflicting fundamentals, should therefore be interesting – and worrisome – for those in the oil game. It’s abundantly clear by now that markets are inherently fickle when it comes to pricing geopolitical risk in, or out the market. The key question is, just how fickle? No sooner had the barricades been broken in Cairo than talk of ‘political contagion’ in the Middle East broke out across the trading floors of London and New York. Events in Tunisia obviously provide a handy ‘straight line’ narrative: Ben Ali has fallen, Mubarak is on borrowed time, Iran is still simmering from the ‘Green Revolution’, any one of the decrepit monarchical regimes in the Gulf could be next. Saudi Arabia, Kuwait, UAE and even Qatar are all on the list, as are Algeria, Libya and Morocco in the Maghreb. Or so the story goes.

While it’s no doubt true that such states share similar structural flaws and deep political fault lines, it’s even truer that they have prolific track records of containing the sources of social unrest through political repression rather than addressing the underlying causes. That is the fundamental ‘call option’ here: stability will be maintained as far as the key oil producing states are concerned.

But the crux of the problem of course is that the (mis)perception of political risk can be just as potent for the market, if not more so, than the actual risks themselves. If the Egypt crisis is anything to go by, then geopolitical factors have only just started to come into play again. The $6 price spike from the chaos in

The $6 price spike from the chaos in Cairo will look like small beer compared to the more explosive geopolitical problems down the track
airo will look like small beer compared to the more explosive geopolitical problems down the track. What if Venezuela, Bolivia or Ecuador enact snap expropriations? Unrest in Central Asia and Latin America could be a problem, as could further upstream slippage in Russia. West African production has been a little stronger of late, but if MEND goes back to full scale war in the Niger Delta, or if chronic corruption in Luanda wards off fresh international investment, then the picture could rapidly change. More dramatically, Yemen could go beyond the point of no political return, with potentially detrimental effects on Bab el-Mandab that carries over 3mb/d. Iran is an even bigger challenge, albeit for well rehearsed reasons.

Import bill

This prospect should come as harrowing news for consumers. OECD States already paid a $790 bn import bill in 2010, up $200 bn from the previous year, which is equal to a loss of income of about 0.5% of OECD GDP. In EU terms that’s an increase of $70bn in 2010, and in the US a $72bn jump. Japan has paid an additional $27bn, while less developed nations are being hit to the tune of $20bn – a figure equal to a loss of income of 1% of GDP. The ratio of oil import bills to GDP equated to 2.1% in Europe, which is on a par with the 2.2% level reached at the height of the market in 2008. One can only imagine what this must be costing emerging markets in subsidies.

For producers high prices might sound like good news, but there are two major risks. The first is potential demand destruction. The assumption in 2008 that demand had become relatively inelastic

Speculators like nothing more than the risk of geopolitical calamity to make a killing
proved to be a grave miscalculation. Most producer regimes were lucky to survive the shock. Whether $100/b will break the bank again remains to be seen, but with anaemic growth in the West and inflationary pressures gathering steam in the East, it would be foolhardy to assume that anything north of $100/b would be a positive development for the global economy.

This directly links to the second risk for producers: they will rapidly lose control of the market if geopolitics starts dictating benchmark prices far beyond the fundamentals in play. Price hawks such as Iran, Algerian, Nigeria, Venezuela (and indeed Russia outside OPEC) probably have no problem with that – it’s not like they have any excess supply to put on the market anyway – but for the swing producer, Saudi Arabia, it creates the age old problem of either going along with the hawks to maximise receipts, or regain control of the market by providing greater supply. Price signals have not prompted any actions so far, not least because Riyadh has been busy blaming speculation for upward price movements rather than fundamentals. No doubt that’s partially true, but that’s the whole point: speculators like nothing more than the risk of geopolitical calamity to make a killing. Egypt has sent a clear signal to OPEC: quell the market now, or it will politically emasculate you later.

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