Everyone is unambiguously familiar with the concept of the “Geo-Political Risk Premium” in oil markets. More or less a catchphrase for political troubles in the Middle East and a consequent extra price (premium) that then gets added on to the market price of oil, due to the chronic fear of a serious supply disruption.
Anyone heard of a “Geopolitical Risk Discount?” Probably not; yet, that is a phenomenon we are increasingly likely to see in the short-term --due to a snowballing Shia-Sunni divide across the Mid-East (& especially in Iraq), that is on its way to deeply splitting the OPEC -- after prices have already come down in the last few weeks at its fastest pace ever, since the invasion of Iraq. I think this growing new source of regional conflict (particularly Saudi Arabia versus Iran), for once, provides a short window of lower prices that has some interesting implications for investors and policy makers.
Before progressing further let me also emphasize up front that –from a long-term demand perspective-- not much has changed around the world. In that, I subscribe to the view that, within broadly unchanged technological attributes and environmental conservation standards, the structural forces that are almost bound to drive prices higher (than they are now), in future years, are definitely out there. However, from a short-term demand perspective, a couple of odd things have conspired to lower oil prices. First is the freakishly warm winter weather pattern in the U.S. and in Europe. Then there is the lack of any lingering Y/Y hurricane related impacts that last year (at this time) caused higher prices. And last but not least, the combination of these 2 referenced factors have also enabled an improvement of inventory positions around the world and strengthened the case for lower prices in the coming 3-6 months (and possibly longer).
In the remainder of this article –which is premised on growing Saudi-Iran tensions- I try to develop a very rudimentary framework for: establishing intent that forms the basis for conflict; assessing capability that is likely to lead to usage of oil as the main weapon; guesstimating ST outcomes that I think will be characterized by prices operating within a narrow range; and, lastly, highlighting implications for investors and policymakers.
Intent:
The Saudi perspective:
There has been an enormous increase in concern within Saudi Arabia and in the rest of the Sunni-dominated Mid-East about the implications of a Shia dominated Iraq that is closely aligned to a nuclear armed Iran. A thorough analysis of the causes of tension would of course need to be politically intricate and historically nuanced –neither of which I am seeking to accomplish in this web-blog. But, what is clear, is that, as the growth in political power of one protagonist (Iran) becomes an ever growing reality --amidst an emasculated balancing role of a chastened or even demoralized U.S.-- the prospects for the other protagonist (Saudi Arabia) becomes increasingly less secure from almost every single strategic vantage point. In other words, if Iran’s power were to rise unchecked in the region, Saudi Arabia would: 1) have to deal with a substantially powerful partner (& combined with direct or indirect control of Iraqi oil, another potential swing producer) within OPEC; 2) could see its religious domination of the Islamic faith challenged by an alternate religious power, a quasi-politically united Iraqi-Iranian Shi’ite clergy, centered in Qom or Kerbala; and 4) face the prospect of seeing its vast political and moral influence in almost all Islamic and regional multilateral frameworks – OIC, Arab League, GCC, Mid-East peace processes- be challenged, if not outright threatened. And last, but not least, Saudi Arabia (& other gulf states) could face a direct internal challenge if the Iraqi/Iranian Shi’ites were to decide- someday- to incite their co-religionists (a large minority) within the oil rich kingdom(s).
The Iranian perspective:
Iran finds itself at a historical cross-road; on the verge of establishing an enduring socio-political influence on its predominantly Shi’a, but traditionally Sunni dominated, western neighbor and is only a few years away from nuclear capability. This is a historical opportunity in that, not since the days of the Safavid empire, or in even earlier –pre-Islamic- centuries of Persian hegemony over the rest of the region, has Iran faced a clear and present opportunity to establish its political, military and economic security and pre-eminence across the entire region. For so long have the Iranians (especially its Shi’a self-identity) been the underdog in a region dominated either by Arab Sunnis or, subsequently, by western powers, that its popular culture is dominated by the cults of martyrdom and belief in the return of the Mahdi (the mythical 12th Imam, who will redeem mankind). Thus, the prospect of: 1) a weakened West, as exemplified by the lack of the U.S.’ practical or sustainable military/political options in Iraq, coupled with 2) long-term structural demand pressures on oil, and 3) ongoing nuclear enrichment -- all provide it with the building blocks for securing the political and military basis for establishing regional security; if not outright dominance.
Taken together, Saudi Arabia and Iran, the region’s two pre-eminent Islamic and oil –producing heavy weights are unambiguously locked in a struggle for power in a growing political vacuum that is Iraq. So far Iran has exercised its power through its proxies in the region – Hezbollah in Lebanon, and the (Moqtada-led) Mahdi army in Iraq. Saudi Arabia has not really done much in response, in light of the heavy U.S. involvement, thus far, in Iraq. But clearly, the demographic and religious tide within Iraq favors its Iranian competitor. The question that then arises is can the ongoing U.S. “Surge” negate everything that the Iranians have gained in Iraq since 2003? My answer would be probably not, short of a limited U.S. war against Iran itself. But even limited coercive action against Iran will be subject to profound U.S. congressional objections and adverse world opinion. So it is for the Saudis to take up the gauntlet themselves.
For now --short of backing Sunni insurgent terror groups, which the Saudi’s are extremely cautious about (for risking association with Al Qaeda type elements)-- the only effective weapon that the Saudi’s can realistically employ is their enormous oil production ability to keep oil prices low in order to try and constrain Iran’s ability to finance further conflict in the region (be it in Iraq or Lebanon or in the West Bank/Gaza areas). Yet another reason for the Saudis to actively employ the oil weapon at this juncture, has to do with the recent deterioration in the health of the Iranian economy on account of poor management by the Ahmadinejad administration. This fact is evident, in the recent losses suffered by the supporters of the Iranian President, in local elections due to popular frustration with high inflation, and joblessness. This under-appreciated fact could be critical, as the structural fiscal framework of Iran is increasingly encumbered with handouts to Hezbollah, Mahdi army and various other domestic constituents on the basis of ideology (not entirely unlike Chavez’ shenanigans) – thereby leaving it more vulnerable to a dip in oil prices. On the other hand, the Saudis and their Gulf Arab neighbors have either built up large net external creditor positions or are paying down their stocks of public debt. Additionally, the recent tightening of U.S. sanctions on Iran, with the support of the E.U. and (more reluctantly) China and Russia has left Iran relatively bereft of financing sources which makes either internal fiscal adjustment more critical or higher oil prices more necessary.
Capability:
A simple look at the at the attached table (Table 1, below), which is taken from the IEA (Int’l Energy Assoc) website shows that, per November ’06 data, Saudi Arabia and its regional OPEC allies (Persian Gulf based kingdoms/Emirates – Kuwait, UAE, Qatar), are producing something in the region of 14.8 millions of barrel of oil per day (mbd), and have a vast advantage over Iran and its most proximate OPEC ally – Venezuela- both of whom together produce roughly 6.2 mbd. Note that the Saudi coalition can bring upwards of 2.2 mbd into world markets on short notice – this amount is the difference between current production and spare capacity. Note also, that Iran + Venezuela are, as of Nov ’06, already producing 1.2 mbd below their production targets (either because of production constraints or due to more strenuous ongoing efforts to hold down prices). In other words, given a starting point of oil prices at roughly $50/barrel, and the Saudi coalition poised to throw in another 2.2mbd (approximately 3% of total estimated 2006 world demand) and the Iranians and Venezuelans either already doing their utmost to prop up prices or being hampered by ST production difficulties – oil prices have little place else to go but hover around the $48 - $55/barrel range (based on the ST ebb/flow of global demand and timing of Saudi+Gulf overproduction). I think the Saudis will stick to this strategy, as evidenced by their pointed shrugging off of the recent decline in oil prices, rejection of calls –at the behest of the Iranians- for another OPEC (production cut) meeting. Moreover, the Gulf Arab countries have expressed support for the U.S. surge in Iraq, and they too remain painfully aware of the limitations of their ability to influence political events in the region with the exception of modulating oil production and pricing trends.
A caveat of all of this analysis is that it ignores other OPEC, as well as non-OPEC, production trends, capabilities, and actions. Barring Saudi, Kuwait, Qatar, UAE, Iran and Venezuela, all other OPEC members collectively account for just 30% of total OPEC production. Moreover, as again can be seen from the graphs, barring Iraq, such (non-heavy-weight) OPEC members –taken together- are more or less producing at the level of their production quotas, with an additional spare capacity of a modest 0.6mbd. From such levels, these OPEC members could –collectively- very well decide to cut production to put some upward pressure on prices. But, I do not think this will be a viable policy choice since ongoing capacity problems in Indonesia and political issues in Nigeria are the main drivers of most of the compliance (of small OPEC states) with production quotas. If the Saudi alliance were to decide on a sustained course of high production and low prices, such countries as Algeria and Libya really do not have the market wherewithal to counter the low price trend; or they risk facing much lower market share (which then becomes a long-term revenue problem).
As far as Non-OPEC countries are concerned, I think there are indeed some production slippage risks with Pemex in Mexico; we could probably also see a slowdown in Russian production (because of the government’s interventionist stance in oil projects and contract negotiations); though, offsetting these potential setbacks could be higher production in such countries as Azerbaijan, China and Kazakhstan.
In all, in the context of current global demand of roughly 84 mbd yes there are some production slippage risks; though, I do not feel they are either too great or imminent enough to temper my overall ST market call on global oil prices as noted below.
Short-term Outcomes:
Crude oil prices will probably fluctuate in the $48 to $55 range; a “comfortably numb” range from a producer perspective. I.e., a price-range that ensures growth but not enough revenues for ambitious fiscal outlays by populist (or politically aggressive) oil producers. A return of colder weather, stronger than expected global growth, and further geo-political problems say in Lebanon or Nigeria could fuel the risk premium concept and temporarily take prices above $55. But, I think –in the coming few months- the Saudi-Iran conflict potential is compelling and well grounded in political and economic strategic theory to warrant an oil production-based response from Saudi Arabia that will tend to hold back ST prices from rising too much on a sustained basis.
I will concede that there is at least one substantial risk to the comfortable numbness (of oil prices). And this has to do with the likelihood of an Israeli strike on Iranian nuclear installations, with or without the backing/connivance of the Americans and the Saudis. Here too, I do not think the Israelis will countenance such a drastic step until a few regional events (or some combination thereof) have run their course, such as: 1) the impact of the U.S. surge and its recent “jaw-boning” of Iran (a process that could take at least 3-6 months to play out) and/or 2) the Saudi oil-price war to financially strap Iran and restrain its ideological and proxy-driven aggression in the region (an economic tactic, whose success, or lack thereof, should also become more evident in the next few months). Moreover, the risks of an Israeli strike are not lost upon Iran either. To suffer such a strike and not respond “befittingly” would result in a loss of face. And to react befittingly would raise the outright risk of a broader war, and the concomitant risks of damage to (if not shut down of) the Hormuz straits. At this juncture, even as its growing influence in Iraq and Lebanon unsettles the West + Sunni Arabs, Iran’s future political maneuvering room is narrowing and its international isolation is growing.
Given its narrower international diplomatic position, Iran’s foreign policy establishment is already facing a clear fork in its path. It will soon have to choose between either foregoing greater influence in Iraq or put its nuclear enrichment on the back-burner for now. Put differently: given its growing diplomatic isolation + the sheer military and economic pressure arrayed against it (amidst oil prices at 3-year lows) it may soon become objectively inconceivable for the Iranians to simultaneously dominate a future Iraqi government and also continue developing its nuclear options. In this regard, the Saudi driven oil price pressure could serve as a critical (& not just a rhetorical) reminder to the Iranians of the real limitations of the current course of their policies. There already is considerable anecdotal evidence of a deep debate within Iran of the need to avoid further provocation of America in Iraq and elsewhere, and also considerable domestic alarm at the state of the Iranian economy. If such domestic disgruntlement grows noisy –as might very well be the case- I suspect the West will give this internal debate some more time to play out, before making any hasty moves whose political and military trajectories could become far less predictable or even less controllable.
So, in all, I stand by the expectation of a short-term equilibrium crude oil price of $48-$55/barrel; while recognizing the “blow out” risks of some sort of a limited strike in Iran (though, I feel they remain far from certain and will take more time to crystallize).
Implications:
From a trading perspective, it would make sense to put on “straddles” in the short-term to buy into any oil price dips below $48/barrel or sell on any increases over $55/barrel; with a long-bias beyond a 6 month time horizon
From a policy perspective: the next few months may seem like a good time for monetary authorities around the world to relax their guard against a critical source of headline inflation, but –in my view- it might be more prudent to leave rates alone and let lower CA deficits (at oil importing countries) work their way through releasing more liquidity and assisting the growth contribution from the external sector. A quick monetary loosening impetus may subject country specific asset markets to excessive liquidity, and leave inflation fundamentals ultimately vulnerable to either the medium term structural risks of a climb up in oil prices or the less probable, but high impact, risk of a price “blow out.” The latter risk could come to the fore if the principal protagonists – against the noted odds- act too hastily or irrationally.
